Business valuations are required whenever a company is looking to raise funds, sell a stake, merger and acquisitions, financial reporting, etc. Under all these transactions, the company is required to determine fair value of its equity.
WAs per IVS 05 Valuation Approaches and Methods of the International Valuation Standards, the following three approaches are used.
- Asset Approach
- Income Approach
- Market Approach
The asset-based valuation approach is based on the value of the underlying net assets of the business, either on a Book Value basis or Net Asset Value basis or Liquidation Value (realizable value) basis. The Asset Approach is generally considered to yield the minimum benchmark of value for an operating enterprise. Under Book Value Method fixed assets and current assets are valued at book value, whereas investments are valued at market price. Net Asset Value represents net equity of the business after assets and liabilities have been adjusted to their fair values. Lastly, the Liquidation Value of the business represents the net present value of cash flows from liquidating the Company’s assets and paying off its liabilities.
The Income Approach serves to estimate the value of a specific income stream with consideration given to the risk inherent in that income stream. The most common method under this approach is Discounted Future Cash Flows. The Discounted Future Cash Flows (DCF) method discounts projected future cash flows back to present value at a rate that reflects the risk inherent in the projected earnings.
Hence the two key ingredients of this approach are:
- Future cash flows
- Discount rate
This is also known as the comparable company valuation method or the relative valuation method. Under this method, value of the shares of a company is arrived at by using multiples derived from valuations of comparable companies, as manifest through stock market valuations of listed company. This valuation is based on the principal that market valuations, taking place between informed buyers and informed sellers, incorporate all factors relevant to valuation. Relevant multiples need to be chosen carefully and adjusted for differences between the circumstances. Value of business is determined by applying appropriate multiple obtained by analyzing information related to various comparable companies. Comparable companies are obtained by applying logical judgments keeping factors such as Turnover, Products, Services, Business environment, Profit margins, Scale of operations etc, in mind. Outlier multiples e.g. negative multiple or very high/low multiple as compared to the industry average multiples are ignored.