Firm valuation methods and approaches

Firm Valuation

Several reasons exist as to why an individual or a corporation may need to value a business. Such reasons may include the need to buy a business or execution of a merger and acquisition. The other reasons may be due to loan or taxation purposes. The process of business valuation is usually not easy as coming with a valid figure requires a lot of efforts amidst different challenges.

A true business valuation requires not just looking 'firms' previous year financial statements. The valuation process requires a complete and thorough process of analyzing several years of the firms' business operations and even the option of future business forecasting, the future economy and the various ways in which the firm will cope with the future market competition.

The presence of very many hard to measure variables that are intangible in nature makes the process of business valuation very complex. This spells it out that it is more than a process of summing up various numbers gathered from a variety of financial reports. It is for this reason that the process of business valuation has been referred to be more of an art than science. The process of business valuation therefore has been estimated to be varying to as much as 30% by experts.

There must be a high level of consistency in the methods employed. However there is usually no consistency in the naming of the techniques used. Each technique or method can be referred to using a variety of names.

The main important factor however, is the in every valuation that is undertaken, the technique employed must be relevant to the type of business operations in question. This aids in the realization and achievement of valid and very supportive figures.

The presence of several valuation techniques then makes the process very confusing and hence the need to hire a professional for the process to be a success. Each method has its merits and demerits. It is also worth noting that there is always a new valuation method being discovered now every now and then.

Valuation Methods

Adjusted Book Value

This is based on the assets and liabilities of the business. It is one of the least controversial methods of business valuation

Asset Valuation

This method is used in the retail and manufacturing process business valuation. This is because these business processes entail a lot of physical assets inventory. This method is based on the existing inventory while also focusing on the improvements that have occurred to the physical space that is utilized by the firm. The valuation method also includes discretionary cash that is has been made from the adjusted income statement.

Capitalization of Income Valuation

This method is usually employed by service-based firms. The method places a lot of weight and value on the intangibles while at that time giving no credit to the physical assets available. The capitalization level is defined in this case as the degree of Return on Investment expected. In short, what one does in this process is to rank a given list of factors or variables with a score system that ranges from 0 to 5.The weight is given according to the weight of these variables to the business process. The scores are then average for the given capitalization rate and then deployed as the multiplication factor of the evaluated discretionary income in order to arrive at the firm's value.

Demerits: Can only be utilized in service-based firms since it neglects the value of physical assets.

Capitalized Earning Approach

This method is anchored on the rate of return in earnings that is expected by the investor. In the case of no risk investments, an investor would expect an eight percent. A rate of twenty five percent is however expected for small businesses.

Demerits: This method is noit reliable sine it based on predictions. Predictions however are usually affected in many ways by certain levels of business uncertainty caused by the fluctuating market and demand dynamics. The global economic changes are also a major influence on this method and therefore other micro determinants such as political environment and international relations heavily affect this method

Cash Flow Method

This method is based on the amount of loan that one could obtain on the business' cash flow. Adjustments are then made on the cash flow in order to take care of effects of amortization, rate of depreciation and even the equipment replacement. The loan amount is then evaluated using the traditional business loan calculations. The amount of loan is then assumed mto be the value of the business.

Demerits: Does not show the absolute value of the business.

Cost to Create Approach

This method is employed when the buyer wants to acquire an already operational firm. This is usually the aim of saving on costs related to start up and time of registration. The buyer then approximates what it would have cost to initiate the start up minus the missing components of the business and then adding the premium for the time saved in the process.

Demerits: This method is not entirely accurate since it might result in the acquisition of liabilities that were run by the previous business owner such as unpaid loans.

Debt Assumption Method

This method normally results in the highest price. It is based on the level of debt a business can have while using the cash flow to repay the debt

Demerit: This method assumes that the business will work normally under perfect condition during the repayment period. It does not usually take care of the worst business case scenarios such as financial crunches in the general or the specific economic sector.

Discounted Cash Flow

This method is anchored on the assumption that a dollar that is obtained today is worth more than a dollar that is received later in the future.

Merits: It takes care of the projected earnings of the business and gives adjustment factors for real growth based on inflation and risks.

Excess Earning Method

This method of evaluation bears sticking similarity with the Capitalized Earnings Approach. However, the return on assets is computed from other earnings that are interpreted as the "extra" earnings that are generated. This method estimates the return on assets from a given industry average.

Demerits: Assumes that the firm performs within the industries average. A performance above or below this average would result in wrong evaluation

Multiplier or Market Valuation

This method employs the industry average multiplier of sales figures from the most recent business sales .An example would be that a certain industry multiplier for the marketing firm could be taken as .85 which is then used to multiply the annual gross sales value in order to arrive at the value of the business.