Take a look at a professional business appraisal report and you will see the valuation date prominently displayed. Clearly, business appraisers deem this date worthy of mention. Why is this the case?
Business value changes over time
Business value can change quite a bit depending on circumstances that change over time. If you pay attention to the public stock market you will spot the ups and downs in prices as investors become aware of new company information and fluctuations in the economy.
An abrupt drop in company’s profits is a cause for concern and can depress its value significantly. If businesses can’t get required capital on attractive terms, their ability to invest for the future could be impaired. The result is often lower earnings and a drop in business value. A major customer departure could put a kink in a company’s sales and knock its value down.
Beware of valuation multiples that are out of date
If your valuation uses the market approach, comparison to similar companies should be done in a timely manner. Market comps depend critically on your ability to assess the current values of similar companies relative to their revenues, profits, asset bases or equity. As the market sentiment changes, so do the relationships between business financial performance and its value. Stale valuation multiples are one reason business valuations go south.
Business valuation repeated at different times
To make things even more interesting, your business valuation may be done as of several dates. This is common in divorce cases when the parties seek to establish how much business value has changed over the course of marriage of the business owners.
In the unhappy scenario of having to do a business appraisal for litigation, the court may determine what dates you should use. Before taking on the job, consider carefully whether you can do business valuation as of the dates the court wants. You may have little choice but to comply and your ability to complete the valuation engagement could prove critical to your client’s success.
Can you use financial ratio analysis in business valuation? If done correctly, this could be a helpful adjunct in your valuation. Specifically, reviewing financial ratios could help you spot the company’s strengths and weaknesses, and compare its performance to industry peers.
Here are the major groups of ratios to consider in valuing a company:
- Short-term liquidity ratios such as current and quick ratio
- Activity ratios including the inventory and accounts receivables turnover
- Risk analysis figures such as business risk and degree of operating leverage
- Balance sheet ratios indicating leverage and equity to asset ratios
- Fixed charge coverage ratios, indicating sufficiency of cash flow to cover debt service
- Return on investment ratios such as return on total assets and equity capital
You can take advantage of the financial ratios in your business value analysis in a number of ways. Selecting valuation multiples in calculating the company’s market value is one area. The multiples are typically calculated from a data set based on several comparable companies. Riskier businesses tend to be assigned lower valuation multiples, while the firms with better financial performance could command higher valuations.
If your subject company compares favorably in terms of key financial ratios, its value is likely to be at the high end of the range. For example, consistent, stable history of earnings is a good justification to pick higher valuation multiples based on EBIT or EBITDA earnings.
In general, the higher the level of business risk revealed by your financial ratio analysis, the lower the business value, whether calculated on the company’s revenues, assets, or other financial variables.
You can uncover important trends in company’s financial performance by examining the ratios over time. Such trend analysis can help you demonstrate how the company has improved or fallen back within the period. Since business value is a forward looking concept, such trends help you identify significant business risks likely to impact what the business is worth.
If you need to support your selection of valuation multiples, compare your company’s financial ratios to its industry peers. If the company shows strength relative to others, then higher valuation multiples are reasonable. On the other hand, poor financial performance should guide you to choose lower valuation multiples.