With all the choices of methods you have for business valuation the question is: which of the methods is the most accurate. In truth, the accuracy of your business appraisal depends mostly on your specific situation and the set of assumptions you make.
In fact, the selection of business methods varies on the case by case basis. As an example, let’s say you are valuing a restaurant. These types of businesses are plentiful and often sell. As a result, there are enough comparable business sales to check against. So valuing an established restaurant based on market comparables makes sense.
But what if you are valuing a technology company that is a pioneer in the industry? Chances are there are few if any companies that offer the same or even similar set of products or services. Businesses in such an emerging market segment do not sell often until they prove themselves and become well established. Here the market comparables may not exist. You are likely to fall back on the income or asset based business valuation methods.
Still other companies may be unique in some ways compared to their competitors. A company that has established itself as a leader in its market over a long period of time may have considerable customer following. The issue of business goodwill may become very important in such a case. To handle the valuation properly, you could choose the capitalized excess earnings valuation method to calculate the value of business goodwill.
Some businesses distinguish themselves by being cash cows. They produce very stable earnings year after year. Capitalization of income valuation methods are likely to produce very accurate results when valuing such companies.
How about a start-up? A young company may be full of promise but has yet to show its true colors when it comes to winning a large customer base and turning a profit. Its value may be tied up in its long-term potential. Forecasting future business earnings, estimating the risk and coming up with an accurate idea of business value may lead you to a different choice like the discounted cash flow method.
As you can see, accuracy of any business valuation method depends on what you are valuing. Consider what the company has to offer, what its value creating potential is, and how it sets itself apart from the competition. Make the right assumptions, such as a well thought out earnings forecast and risk assessment, and the methods you choose will likely produce an accurate, defensible result.
Take a look at how the various business valuation methods work:
See Example »
The discounted cash flow method is perhaps the most versatile valuation method under the income approach. Professional business appraisers, venture capitalists, bankers and entrepreneurs use this method to value all kinds of businesses and professional practices. Just about any business with a solid expectation of future earnings can be valued by this powerful technique. You can use this valuation for a business of any size in any industry.
The method calculates the so-called present value of future cash flows that are projected over a finite period of time. But business people and investors can envision what the company is likely to do only so far into the future. Beyond a certain point uncertainty reigns.
To handle this common situation, the discounted cash flow method uses an additional calculation. This is often referred to as the terminal value. The idea is that after the yearly earnings forecast is discounted, the company still has some residual value if the goal is to keep running the business. The terminal value uses the capitalizing calculation, dividing the last projected business earnings by the cap rate.
In other words, the discounted cash flow method works like this: first, calculate the present value of future earnings that you can forecast with reasonable accuracy. Next, assume that the business will keep running and its earnings will grow at some constant rate year over year.
In this case, you can use the capitalization calculation to estimate what the terminal or residual value of the business is. Now add the present value of the forecast business earnings and the terminal value, appropriately discounted, and you have the total business value as of today.
Terminal cap rate – the biggest source of mistakes
Pay special attention to the capitalization rate you use. The cap rate is the difference between the discount rate and the expected earnings growth rate over the long term. The key point here is that the earnings growth rate must be sustainable and should not exceed the discount rate. Otherwise the cap rate can become either too small or even negative making the terminal value calculation useless.
To do a sanity check on your earnings growth rate, compare how quickly the earnings grow in your industry sector. Take a look at a few well established competitors to see how well they are doing. Chances are this will reveal what earnings growth rates are sustainable.
Discounted Cash Flow Valuation