Origin
Business valuation dates back to the early days of capitalism, when merchants began exchanging products and services. As the economy became more complicated, determining the worth of enterprises became vital in order to make educated judgments about investments and mergers.
Definition
The process of evaluating the worth of a business or company based on a range of factors such as the company’s financial performance, assets, liabilities, and market position is known as business valuation. The goal of business valuation is to produce a fair and accurate evaluation of the company’s worth for a range of purposes such as mergers and acquisitions, estate planning, and taxation.
Methods
| Method | Pros | Cons |
|---|---|---|
| Asset-Based | Simple and straightforward; useful for companies with tangible assets | Ignores future earning potential and intangible assets such as intellectual property or brand value |
| Income-Based | Takes into account future earnings potential and growth; more accurate for companies with a proven track record | Difficult to estimate future earnings accurately and requires assumptions about future growth and discount rates |
| Market-Based | Based on actual market demand and transactions; useful for companies with similar peers in the market | Limited market information and may not be applicable for unique or niche businesses |
Calculation
1. Asset-Based approach
The asset-based method determines the value of a company by adding the value of its assets and subtracting the value of its liabilities. Here’s an illustration:
Assume a small manufacturing company has $500,000 in assets and $300,000 in liabilities.
Applying the asset-based technique, the company’s value would be:
$500,000 in total assets – $300,000 in total liabilities = $200,000 (company value)
Hence, adopting the asset-based method, the company is worth $200,000.
2. Income-based approach
1. Predict future earnings: Assume a software firm has a projected yearly sales of $500,000 and a 10% annual growth rate. We can utilize a predicted income statement to project the income over the following five years to estimate its future earnings.
| Year | Revenue | Growth Rate |
|---|---|---|
| 1 | $550,000 | 10% |
| 2 | $605,000 | 10% |
| 3 | $665,500 | 10% |
| 4 | $732,050 | 10% |
| 5 | $805,255 | 10% |
2. Discount Factor Calculation: The discount factor is the rate at which future cash flows are discounted to their present value. Let’s say the company’s discount rate is 12%.
| Year | Discount Factor |
|---|---|
| 1 | 0.893 |
| 2 | 0.797 |
| 3 | 0.712 |
| 4 | 0.636 |
| 5 | 0.567 |
3. Calculate Present Value: The present value of future profits is estimated by multiplying predicted earnings by the discount factor and adding them all together.
| Year | Future Earnings | Discount Factor | Present Value |
|---|---|---|---|
| 1 | $550,000 | 0.893 | $491,900 |
| 2 | $605,000 | 0.797 | $482,185 |
| 3 | $665,500 | 0.712 | $473,738 |
| 4 | $732,050 | 0.636 | $465,573 |
| 5 | $805,255 | 0.567 | $457,689 |
4. Calculate Terminal Value: The terminal value represents the business’s expected value beyond the forecasted timeframe. Typically, this is calculated by assuming a growth rate and a terminal year.
Assume a 3% terminal growth rate and a year 5 terminal year.
Terminal Value = ($805,255 x (1 + 3%)) / (12% – 3%) = $9,664,978
5. Calculate Terminal Value Present Value: The terminal value’s present value is calculated by discounting it to its present value.
Present Value of Terminal Value = $9,664,978 / (1 + 12%)^5 = $4,396,015
6. Add Present Values: The total present value of the firm is the sum of the present values of expected earnings and the terminal value.
Total Present Value = $491,900 + $482,185 + $473,738 + $465,573 + $457,689 + $4,396,015 = $6,767,100
3. Market-based value
1. Gather necessary information: Assume we wish to determine the worth of a consumer electronics manufacturing company. We choose three publicly traded firms in the same industry that are comparable in terms of size, operations, and growth potential.
The following information is then gathered:
| Company | Market Capitalization | Revenue | Earnings |
|---|---|---|---|
| Company A | $2 billion | $500 million | $50 million |
| Company B | $1.5 billion | $400 million | $40 million |
| Company C | $2.2 billion | $550 million | $60 million |
2. Compute valuation multiples: Following that, we compute the valuation multiples for each of the companies. Valuation multiples are ratios that compare the market worth of a firm to a financial statistic such as revenue or earnings.
Price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, and price-to-book (P/B) ratio are all common valuation multiples.
| Company | P/E Ratio | P/S Ratio | P/B Ratio |
|---|---|---|---|
| Company A | 20x | 4x | 2x |
| Company B | 18x | 3.75x | 1.8x |
| Company C | 22x | 4x | 2.2x |
3. Calculating average of valuation: We can then calculate the average of the valuation multiples for each metric:
| Valuation Metric | Average Valuation Multiple |
|---|---|
| P/E Ratio | 20x + 18x + 22x / 3 = 20 |
| P/S Ratio | 4x + 3.75x + 4x / 3 = 3.92 |
| P/B Ratio | 2x + 1.8x + 2.2x / 3 = 1.97 |
4. Calculating subject company value: The average valuation multiples are then applied to the financial data of our subject company. Assume our subject company generates $600 million in revenue and earns $60 million.
| Valuation Metric | Subject Company Value |
|---|---|
| P/E Ratio | $60 million x 20 = $1.2 billion |
| P/S Ratio | $600 million x 3.92 = $2.352 billion |
| P/B Ratio | $60 million x 1.97 = $118.2 million |
The average of the three figures is then used to calculate our estimated value for the subject company:
Average Value = ($1.2 billion + $2.352 billion + $118.2 million) / 3 = $1.223 billion
4. Make specific adjustements if necessary: Lastly, we make any modifications necessary to account for variations between the subject company and the comparable companies. If the subject company, for example, has a stronger brand or greater growth prospects, we may modify the valuation upward.
Similarly, if the subject company’s financial status deteriorates or it faces increased competition, we may reduce the valuation.
Example
Assume its brand power is expected to bring a 10% premium to our valuation.
To begin adjusting our valuation, we calculate 10% of the unadjusted valuation:
10% x $1.223 billion = $122.3 million
We then add this amount to our unadjusted valuation:
$1.223 billion + $122.3 million = $1.3453 billion
This adjusted valuation of $1.3453 billion takes the subject company’s better brand into account and provides a more accurate approximation of its genuine value.
Valuation importance
Business valuation is important for a variety of reasons:
1. Legal objectives: In addition to shareholder conflicts and divorce settlements, business valuation is vital for legal considerations. In these situations, a proper valuation can assist in determining the fair worth of the firm and ensuring that all parties involved receive an equitable portion.
2. Raising capital: When a company seeks money, investors will want to know how valuable the company is. An correct valuation can assist investors in determining if the company is a suitable investment and what percentage of ownership they should receive in exchange for their investment.
3. Estate planning: Company valuation is critical in estate planning, especially when estate taxes are involved. A business owner must understand the worth of their company in order to select the best strategy to pass it on to their heirs.
4. Selling or buying a business: When a business owner wants to sell their company or a potential buyer wants to acquire a company, a correct valuation is critical. A seller wants to get a fair price for their firm, whereas a buyer wants to pay a fair price based on the true value of the business.
Consequences of fraud
• Legal ramifications: Businesses that manipulate their valuations are frequently sued. Fines, penalties, and criminal charges may be imposed on executives implicated in the scam. Companies may also face litigation from investors who were misled by the inflated valuations in some situations.
• Loss of investor trust: Businesses that alter their valuations risk losing the trust of investors and other stakeholders. Investors may lose faith in a company‘s leadership and capacity to deliver returns if they realize that its valuation has been fraudulently inflated.
• Loss to reputation: Businesses that distort their valuations may suffer considerable reputational harm. They may risk bad media coverage and public outcry in addition to losing investor faith. This may make it harder for the company to attract future consumers, staff, and partners.
Examples
• Enron: Enron engaged in deceptive accounting methods in the early 2000s to inflate its stock price and financial performance. This included exaggerating the worth of its assets and concealing its obligations. Enron filed bankruptcy once the plot was revealed, and numerous executives were prosecuted with fraud and other offenses.
• Theranos: Theranos, a blood-testing firm, was once valued at $9 billion, but it was later proven that the company’s technology did not function as stated. The company and its creator, Elizabeth Holmes, were charged with fraud and other offenses, and the company eventually went bankrupt.
The Future
Future technology has the potential to make manipulating company valuations more difficult. Tokenization of assets is one example of this.
Tokenization is the process of transforming an asset into a digital token that can be used on a blockchain. This technology has the potential to make asset ownership and value tracking more transparent and precise. For example, if a corporation tokenizes its assets, it will be more difficult for it to overvalue or undervalue them without being detected.
Tokenization can also improve openness and precision in the valuation process. With a digital record of ownership and transaction history, investors and analysts may find it easier to verify the value of an asset or organization. This may result in more accurate values and a lower chance of fraud or manipulation.
Other technologies, such as artificial intelligence and machine learning, may play a role in enhancing firm valuation in addition to tokenization. These technologies are capable of analyzing massive volumes of data and providing more precise and impartial appraisals based on a broader range of parameters.