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Company Valuation Method Definition
Business valuation is a method of appraising the economic value of a business or company. Financial market players use valuation methods when buying or selling a business. Valuation also becomes relevant in divorces, litigation, property-estate or gift taxation. It is also relevant whenever there is a transfer of ownership interest, such as partner buyouts.
A Little More on Public Company Valuation
Before undertaking valuation, it is important to understand the purpose “premise of valuation” and and context “circumstances” for valuation.
There are various standards of valuation. These affect the definition of valuation in a specific context. The primary types are as follows:
- Fair market value, in which the value of a product or service is determined between a willing seller and buyer with full knowledge of all the important facts.
- Investment value, which is simply the value of the business to a specific investor
- Intrinsic value, which shows the investor’s existing knowledge of the business’s remunerative potential.
The purpose behind the valuation will also affect the methods of valuation and how it is carried out.
- Going Concern – Value resulting from continuous use as an ongoing business operation. This normally involves market-based methods or cash-flow methods.
- The assemblage of assets – value from assets owned but not used to carry out business activities. This is generally used for purposes of securing a loan.
- Orderly disposition – value got from the exchange of business assets, where assets are sold off individually and not used to carry out business activities. This generally useful in spinoffs of company subsidiaries.
- Liquidation – value got when business assets are sold off in a forced liquidation.This is generally relevant is bankruptcy proceedings.
There are various elements to consider when carrying out a company valuation:
- Economic conditions; A business valuation report usually starts with a comprehensive note stating the objective and range of business estimation as well as the audience and date it was carried out. Next is a summary of the local and national economic conditions as at the date of valuation, as well as the state of the sector in which the subject business functions. Federal Reserve Board’s Beige Book which is issued by the Federal Reserve Bank eight times a year serves as a rich source of information for the first part of the report.
- Financial analysis; The financial report analysis usually involves the ratio analysis, sector comparative analysis, trend analysis, and common size analysis. This allows the valuation specialist to match the subject company to similar businesses in the same industry, and to learn recent drifts affecting the business and/or the sector over the years. Comparison of a business’s financial reports in various time periods allows the valuation specialist to observe the growth and/or decline in expenses or revenues and several other changes in financial trends of a business over time. This will help with the risk assessment and eventually help decide the discount rate to be offered.
Note: Cash flow in the financial statement shows the company’s cash in and outflow.
- Normalization of financial statements; Identification of the company’s ability to generate profit for its proprietors is the main objective of normalization. The volume of cash flow that the proprietors can withdraw from the company without negatively affecting its activities serves as a measure of the profits. Normalization adjustments can be classified into four categories:
- Comparability Adjustments: The valuation specialist may adjust the subject business’s financial reports to accommodate a comparison between the subject business and other businesses in a similar sector or location. Differences in the presentation of published industry data and the presentation of financial reports of the subject business’s data are ruled out with these adjustments.
- Non-operating Adjustments: It is logical to assume that the seller would keep all assets that were not used in the generation of income if the company was sold or sell the non-operating assets independently. As a result, non-operating assets are typically removed from the balance report.
- Non-recurring Adjustments: Events such as the acquisition or sale of assets, an abnormally large expense or revenue, or lawsuits that are not expected to happen again may affect the financial reports of the subject business. These one-time items are adjusted so the business’s financial reports will positively depict the management’s expectations.
- Discretionary Adjustments: The proprietors of private businesses may be paid in a similar manner as executives in the industry are paid. To estimate the fair market value, the proprietor’s earnings, benefits, and privileges must be altered to fit the industry standards. The rent paid for the use of an asset by the proprietors of the subject business may also be scrutinized.
Methods of Valuation
In other articles, we explain the various types of valuation falling under the categories of:
Asset-Based (Cost-Based) Methods
- Overview of Asset-Based (Cost-Based) Methods
- Book Value (and Adjusted Book Value) Methods
- Replacement Value
- Liquidation Value
- Overview of Market Approaches
- Types of Comparables
- Common Characteristic-Based Ratios & Multiples
- Issues with Market-Based Valuation Methods
- Overview of Income-Based Valuation
- Earnings Capitalization Method
- Build-Up Method
- Discount Future Cash Flows
- Excess Earnings Method
- Economic Value Added Method
- Value of Dividends Method
Investor Valuation Methods
- Pre and Post-Money Calculations
- Angel Investor Methods
- Venture Capital Method
- First Chicago Method
- Strategic Considerations in Valuation
References for Public Company Method.
Academic Research for the Public Company Method.
- Corporate governance and firm valuation , Brown, L. D., & Caylor, M. L. (2006). Journal of accounting and public policy, 25(4), 409-434. Gompers et al. formed the G-Index which demonstrated that more self-governing firms are more valuable. The G-Index is a succinct measure of corporate governance obtained by observing 24 firm-specific stipulations.
- The valuation of cash flow forecasts; An empirical analysis , Kaplan, S. N., & Ruback, R. S. (1995). The Journal of Finance, 50(4), 1059-1093. This journal relates the original value of Highly Leveraged Transactions (HLTs) with the reduced value of their matching cash flow forecasts. For 51 samples of HLTs carried out between 1983 and 1989, the result of valuations of reduced cash flow forecasts on average of the original values of the transactions falls within 10 percent. This method of valuation achieves the result as well as methods that use comparable companies and transactions.
- Valuation : what’$ it worth , Mard, M. J., & Mehm, G. (2009). The Licensing Journal, 46-48. This articles explains the use and usefulness of valuation methods in licensing.
- Problems with Cost of Capital Estimation in the Current Environment—Update , Grabowski, R. J. (2008). Business valuation review, 27(4), 209-220. This article addresses the issues of determining what is the specific cost of capital.
- Valuing a business , Pratt, S. P., Reilly, R. F., & Schweihs, R. P. (2000). Valuing a business. The Analysis and. This article provides an overview of business valuation methods.
- Valuation of Business Interests , Haynsworth IV, H. J. (1981). Mercer L. Rev., 33, 457. This article addresses the difficult task of valuation of business interests.
- The economics of Delaware fair value , Margolin, B. A., & Kursh, S. J. (2005). Del. J. Corp. L., 30, 413. This journal established that the same economic concepts used to make the Fair Value standard for appraisals are also used to elucidate the economic makeup of corporation law.
- Global unification of Business Valuation Standards , Szczepankiewicz, E. I. (2013). Management, 17(2), 154-165. This article addresses the realities that business valuation varies considerably across countries and throughout the world.
- An empirical walk down valuation way: Are the valuation methods of closely held companies chosen by the courts a function of the type of case and level of court , DiGabriele, J. A. (2003). J. Legal Econ., 13, 39. This paper explores whether the methods of valuation of closely-held-companies selected by courts are a function of the rank of court or kind of case. The outcome of the research shows that there is a systematic trend in the preferences of the court for several methods of valuation and approaches.
- Minority Discounts, Fair Market Value, and the Culture of Estate Taxation , Blatt, W. S. (1996). Tax L. Rev., 52, 225. This article addresses some of the intricacies involved in the various valuation methods employed when valuing an estate for taxation purposes.
- Takeover Premiums and Discounts for Lack of Marketability in Banking Valuation : Data from Emerging Markets. , Bogatyrev, S. Y., & Dobrynin, S. S. (2015). International Journal of Economic Perspectives, 9(2). The article depicts the power of premium over the market price and the worth of a minority position in the business using the results from emerging markets. The investigation was carried out on the evaluation practices of more than 60 valuation experts from Moscow, Russia.