Archive for June, 2015

Whenever the issue of business valuation comes up, the subject of the best method selection is sure to follow. Perhaps the most common is the market approach. Market based valuations let you compare a target company to other similar firms whose value is known. Such is the case if a number of comparable companies have sold recently, so you can find out their selling prices.

If you know these companies financial performance parameters, then it is straightforward to come up with so-called valuation multiples. These are ratios that relate the business value, or in this case the company’s actual selling price, to its financial performance. Examples are business value based on revenue, EBIT or EBITDA, net profit, cash flow, total assets, or owners’ equity.

If there are enough comparable business sales, you can develop a good set of valuation multiples based on sales statistics. Applying these multiples to your target company is a simple way to develop an idea of the company’s market value range as well as other statistical measures such as the average and median values.

The attraction of market based valuation is that it is ostensibly based on the actual market evidence. If a large enough number of business people work out the typical business market value, then you can surmise that the market has arrived at a good idea of what other, similar companies are worth.

So far, so good. But there are a number of gotchas with the market approach. Suppose you are looking to value a company that has developed a unique set of technologies that make it very different from any other firm. Does comparison to sold companies make sense here?

It is easy to miss some key value drivers in this situation that not only make your company different, but represent the bulk of its value in the first place. Indeed, it may well be that the value potential of your company is defined by the different set of technologies that make it hard to do a meaningful comparison.

Another example is a company that offers unusual products or services. An example would be a big game hunting equipment manufacturer. There aren’t that many businesses of this type that actually sell. So the statistics to do your market valuation are hard to come by and probably unreliable.

In some cases a business can be operating in a number of industry sectors at once. Comparing such multi-sector businesses is hard. Usually, market comparisons are done using statistics from so-called pure play companies, i.e. those operating in a single industry sector. You can look across a number of industries and then average the results. But that still misses the likely synergies the actual business has.

In short, market based valuations may not be the ticket in your case. Even so, you can still value your business using the methods under the income and asset approaches.

These methods help you focus on the company itself and how it creates value. For example, the discounted cash flow method requires that you come up with the business earnings forecast and assess its risk. There is no need for comparison to other firms, you focus directly on your company and its value creating fundamentals.

In such situations, your rationale is that market comparisons are misleading because your business is far too different. It is the income and asset valuation methods that are most useful here, since they help you determine business value directly.

Business Valuation – Choosing Your Methods

There is a reason professional appraisals use the asset, income, and market approaches to calculate business value. Each situation is different, so your method selections may be quite different from someone else’s.

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The income approach assumes that investors have a number of alternatives to put their money into, from risk-free government debt, such as US Treasurys, to venture backed start-ups. In an efficient market, sensible investors demand greater returns for assuming the extra risk. The value of a start-up is seen in the context of this question, “What kind of return can an investor expect for putting the money in a non-marketable start-up?”

The answer depends upon the expectation of future income that the company can reasonably earn. To apply income valuation methods, you need to project future earnings of the company.

This is somewhat easier to do for an established company by looking at its earnings history. The uncertainty is always there, and it is much higher for a start-up with little or no income track record.

Assessment of a public company’s potential earnings is something the investors do as a group every day. That’s the basis for setting the stock prices. In a sense, you can see the collective investor opinion better than predict what the company will actually be able to do in the future.

A number of analysts make a good living offering advice on future business performance. Yet time and again their forecasts have proven wrong. There is always a day of reckoning as the financial publications report just how close a company came to analysts expectations. Disappointing the market expectations can send a company’s stock prices tumbling down.

For a start-up, there is little basis on which to set your expectations. You have to make a judgment call as to the likelihood of business success. Even with an excellent product offering, there is the lingering questions as to whether the business team will be able to turn the potential into actual profits.

It is not unusual to consider a number of possible outcomes for a start-up. You can develop a cash flow forecast for each of the scenarios. Applying the income based methods, such as the discounted cash flow technique, gives you a business value result for each anticipated outcome.

You can then assess just how probable each scenario is. Perhaps the company can meet most of its key objectives and achieve a level of earnings as the best case. On the other hand, unexpected difficulties could limit its progress, and the earnings forecast you create would represent the worst case scenario.

You can use the results of business valuation under each scenario, then combine them to calculate the average. Alternatively, the range of business values can indicate where the actual business worth is likely to fall.

Income based business valuation

Creating a number of future earnings forecasts is a typical way to value a start-up. Since no solid history exists as a guide, running several valuations is a good way to cover possible outcomes.

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