What Business Valuation Methods Should be Used?
A business valuation is simply an opinion on business value that follows standard and best practice methods of arriving at the value of the business.
However there are different methods for valuing a business and each should be used in different circumstances. A business valuation is not simply how to calculate the value of a business - it is a valuation process that produces an opinion that can be relied upon.
We go through some of the theory behind business valuation methods and when to use them.
What Is the Definition of Business Value
The core definition of the value of a business (or any other financial asset) is the net present value of future cash flows. However this is not always easy to calculate and in many cases a business may not have future cash flows that can be predicted with any accuracy.
So in these circumstances how do you value a business and how do you choose the right business valuation method?
First lets consider the business valuation process and some key steps and assumptions!
What Is the Business Valuation Process
A valuation should follow a structured process that meets certain international best practices, in particular:
The business valuation process should be transparent.
The business valuation should be repeatable such that anyone with appropriate knowledge and experience can redo the business valuation and reach the same or similar conclusion.
The method of business valuation should be clearly stated.
All assumptions and information relied upon should be clearly stated.
The business value range should be arrived at using an evidence-based process.
The business valuation process should be consistent with current methodology and industry standards.
We must also make some key assumptions on:
What is the standard of business value to be assesed (market value, strategic value or some other standard - there are at least two more).
Whether we are assessing enterprise value (the minimum assets and liabilities for the business to function - we call these the working assets and liabilities) or equity value?
The date at which to calculate the business value.
When selecting a valuation method, we choose a primary method that is considered the most appropriate under the circumstances, then use other methods as a cross check to the business value arrived at by the primary method.
If we follow these guidelines and assumptions, then the resulting business valuation report will have consistency with other valuations done to the same standard, will be defendable and will be evidence-based.
In this case, the business valuation is more science than art and will be less subjective than other business valuations that do not follow these principles.
Primary Business Valuation Methods
There are five key approaches that are generally used for business valuation. These business valuation methods are:
Market based valuation methods.
Income based valuation methods.
Asset based valuation methods.
Cost based valuation methods.
Rules of thumb valuation methods.
Market based valuation methods typically compare the business being valued with another business where the valuation is known. We often look at listed entities to use as some proxy for the business being valued, or we look at actual transactions where the details are known and the businesses are similar. This business valuation method is often called comparable transactions method, and is often useful in cross-checking other valuation methods.
The income valuation methods are based on the profits or free cash flow of the business and capitalisation of these cash flows at a suitable cost of capital. These include DCF valuation methods (discounted cash flow), future maintainable earnings valuation method or capitalisation ratio valuation methods.
The Excess Earnings methods are similar to this but consider the earnings or income above expected industry levels.
Different authorities (ATO, the courts and ASIC) have a preference for using the above hierarchy when selecting business valuation methods. As long as suitable and reliable information of relevant market transactions are available, they will consider the market based method as being the most representative of market value.
In other cases, such as raising finance for an early-stage startup, the preferred method of business valuation is the "last money in" (a version of the Market based valuation method), or the implied business valuation based on the most recent investment. AVCAL (Australian Private Equity and Venture Capital Association Limited) have published guidelines on this process.
This asset based valuation method considers the adjusted value of the assets and liabilities held by the associated entities to be representative of market value. In essence it represents the adjusted "book value" of the business or entity, taking into account unreported assets and liabilities, both contingent and non-contingent.
Cost based valuation methods are used to determine the cost the business would incur if it was deprived of the current assets and had to replace them in some way. In this manner we are looking at the replacement cost, or what would be paid by the "open market" to replace the assets in some way. This valuation method is often used for technology-based businesses or start-up businesses that have yet to achieve a suitable cash flow.
Rules of Thumb valuation methods are used as the primary method as a last resort, as often these are based on "industry accepted ratios" and are not always comparable across different circumstances. They also make certain key assumptions, often related to the profitability of the business and tend to result in inflated business valations.
Examples of rules of thumb include:
Valuing a rent roll at some multiple (typically ranging from 1.5x - 3.5x) of recurring rent revenue
Valuing an accounting practice at 0.8x - 1.2x recurring invoicing
These rules of thumb are often based on historical transactions, but the underlying assumptions are never explicitly made. For this reason they can be unreliable in some circumstances.
How to Calculate the Value of a Business
We have explained some of the valuation methods mentioned above in greater detail in our Online Business Valuation Guide that takes you through the steps of how to calculate the value of a business.
Making some initial assumptions we have laid out our business valuation process in an easy to follow manual method.
You will first need to download the Valuation Calculation Guide here
Click the button to start your own business valuation process.
If at any stage you have any questions or concerns then send us an enquiry or contact us over the phone. We are always happy to help and educate people of the value of their most important asset.
This valuation process and information is general in nature and is to be used at your own risk and discretion. We take no responsibility for any errors in calculation or judgement that you may make based on our information or advice.
We are not responsible for any commercial loss you may realise as a result of relying on the information or analysis that you complete.