Business Valuation In A Nutshell

Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Understanding a business valuation

These considerations ultimately result in an estimation of the value of the business concerned. While valuations are commonly associated with mergers and acquisitions, they are also useful for:

  • Changes in business ownership or the bequeathing of shares to children as part of succession planning.
  • The raising of investment capital.
  • Divorce proceedings.
  • Establishing the degree of joint-venture partner ownership.
  • Taxation purposes.

Various business valuation approaches

Not all businesses are created equal, so there are several approaches that analysts can use to value a business.

1 – The cost approach.

This approach considers the cost involved in replacing or rebuilding an asset and is commonly used to value real estate or investment securities. It is not typically used to value a business that is a going concern.

2 – The market approach

Here, the analyst will assess the recent sales of comparable public businesses. Valuation adjustments may need to be made if there are major discrepancies between the business being valued and one already sold. 

The market approach incorporates the comparable company analysis, or “comps” for short. This involves a comparison of trading multiples such as P/E and EBITDA – with the latter being one of the most common methods of valuation. Market capitalization, net debt, revenue, size (revenue, assets, employees), and even geographical context are also considered in other methods.

This approach obviously requires that similar businesses exist. Thus, it may be unsuitable for unusual, niche, or highly innovative companies.

3 – The discounted cash flow (DCF) approach

The DCF approach is the most comprehensive of the three because it assesses companies according to their intrinsic worth. The analysis requires that a financial model be created in Excel based on extensive data estimates and assumptions. 

Data is used by the analyst to forecast free cash flow over a projected, future period. This is done by calculating the company’s Weighted Average Cost of Capital (WACC), or the expected returns required by debt and equity providers. 

The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 
In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to build a diversified portfolio able to give satisfactory returns. 

For larger organizations with multiple business units, the DCF approach models and values each unit separately. Then, unit valuations are combined to give a final valuation.

Although requiring significant upfront effort, the results of a DCF valuation are the most accurate.

Key takeaways

  • A business evaluation is a process whereby an experienced analyst values a business or company unit.
  • Business evaluations are commonly seen in mergers and acquisitions. But they are also important in succession planning, capital raising, divorce proceedings, and the establishment of a joint-venture partnership.
  • A business evaluation can be approached in three different ways. Although resource-intensive, the DCF approach is the most accurate because it considers the intrinsic value of a business. 

Related Concepts

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at a fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flows

The cash flow statement is the third main financial statement, together with an income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Financial Structure Modeling

In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.

Tech Modeling

A tech business model is made of four main components: value model (value propositions, mission, vision), technological model (R&D management), distribution model (sales and marketing organizational structure), and financial model (revenue modeling, cost structure, profitability and cash generation/management). Those elements coming together can serve as the basis to build a solid tech business model.

Read Next: Income Statement, Balance Sheet, Cash Flow Statement, Financial Structure, WACC, CAPM.

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