You may have run across a number of financial ratios in trying to analyze a company’s overall performance. The ratios are useful in a number of situations when the company’s financial condition, profitability, and efficiency in using its assets need to be understood.
Using the ratios can help shed light on such important issues as the company’s ability to meet its obligations, its capital structure, how well it uses its resources to generate income, and how profitable it is.
When used properly, the financial ratios can be a useful tool in your business valuation. The obvious benefit is that they can help you spot the company’s strengths and weaknesses and compare it to its industry peers.
Reviewing well selected ratios can help you in your valuation work in a number of ways. Perhaps the most useful area is the selection of appropriate valuation multiples that help you establish the company’s value in relation to its financial performance measures. Valuation multiples are usually derived from comparable business sales, affecting competitor businesses. As a result, you have a statistical range of multiples to choose from.
If the company you value outperforms its peers in terms of profitability, then a higher valuation multiple can be in order. In general, the lower the degree of risk factors that the financial ratios reveal, the higher the company’s value is likely to be relative to its earnings, equity value, and other financial variables.
To pick the right valuation multiple, you would compare the company to its competitors. Areas of relative strength would help you justify a valuation multiple in the high end of the statistical range.
Another way to use ratio analysis is to compare a company’s own figures over time to see if there is a trend. You can spot areas that point up improvement or worsening in company’s performance. This can help you in selecting the discount and capitalization rates most appropriate for your company valuation.
Private company financial statements often require adjustment before you can proceed with business valuation. Be sure you are using the financial ratios consistently. Adjustments for inventory, nonrecurring expenses or discretionary items can greatly affect the ratio figures. When using financial data from an industry sector, be sure your company’s financial statements are adjusted consistent with the industry norm.
Which financial ratios you choose for your business valuation may differ depending on your industry. In general, you should take a close look at the ratios that differ significantly from the industry norm.
One of the key methods in business valuation focuses on assessing a number of value creating factors to calculate business value. Ratio analysis can help you select the proper values for the factors and provide solid justification for your business value results.
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Ask any professional business appraiser about the choice of valuation methods and you will hear that there are quite a few. By convention, the methods are grouped under three major categories, known as approaches. There are three of those: market, asset, and income.
No one approach to business valuation is bullet proof. If you choose just one method or approach, you are likely to face criticism from a discriminating reader.
Perhaps the first choice of business people is the market approach. It is simple and direct, easy to explain and implement. All you have to do is compare your company to a number of similar firms that have sold recently. The selling prices, when related to the companies’ financial performance, give you a way to measure what any other business is worth, provided it is similar enough.
But here is the rub. The similarity of businesses is more often imagined than real. No two companies are exactly the same. Plus business conditions change, sometimes rapidly, affecting what a given business is worth on the market. No two parties to a business sale are ever the theoretical willing buyer and seller. There are always special circumstances that make each deal unique.
So if you use market approach methods to value a company, be prepared to handle objections that comparisons may be misleading.
The asset approach relies on the assumption that business assets do not become obsolete too quickly and that their condition and fitness for service can be reliably established. But consider the fact that a set of business assets on hand is not something you would want to invest in for the future. Perhaps the company needs to upgrade its aging asset base to pursue future opportunities. Thus the business assets may not represent what the business is worth going forward.
Methods under the income approach let you focus on valuation from an investment perspective. The advantage is that you focus on the actual company being valued, not other firms or a set of assets. The idea is that business value is revealed by the company’s ability to generate earnings at an acceptable level of risk. In this sense, the income valuation methods help you focus on the essential reason to be investing in any business.
The downside is that you need to come up with reliable representation of business earnings and risk assessment for the future. Since no one has the crystal ball, any prediction of future earnings can be off the mark. So while the income approach framework is powerful and elegant, the actual results you get in your valuation are as good as your assumptions.
In summary, any business valuation is an expression of opinion. If you trust your analysis, then you can rely on the answer. If you have doubts, it is time to review your assumptions and revise your business valuation.
Business valuation – three approaches
Using more than one approach in your business valuation is best. Various methods let you assess business value from different perspectives. The result is a well rounded conclusion that stands up to the most exacting scrutiny.