Choosing a Business Valuation Methodology

Part 8 – Planning a business acquisition

This part of the series of articles was contributed by:

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Valuation methodologies can generally be split into three categories, as follows:

  • Market Based Methods;
  • Income Based Methods; and
  • Asset Based Methods.

Market Based Methods

Market based methods estimate the fair market value by considering the market value of a company’s securities or the market value of comparable companies. Market based methods include:

  • the quoted price for listed securities; and
  • industry specific methods.

The recent quoted price for listed securities method provides evidence of the fair market value of a company’s securities where they are publicly traded in an informed and liquid market.

Industry specific methods usually involve the use of industry rules of thumb to estimate the fair market value of a company and its securities. Generally rules of thumb provide less persuasive evidence of the fair market value of a company than other market based valuation methods because they may not account for company specific risks and factors.

Income Based Methods

Income based methods estimate value by calculating the present value of a company’s estimated future stream of earnings or cash flows. Income based methods include:

  • discounted cash flow methods (“DCF”); and
  • capitalisation of future maintainable earnings.

The DCF technique has a strong theoretical basis, valuing a business on the net present value of its future cash flows. It requires an analysis of future cash flows, the capital structure and costs of capital and an assessment of the residual value or the terminal value of the company’s cash flows at the end of the forecast period. Forecast future cash flows are discounted by a discount rate that reflects the time value of money and the risk inherent in the cash flows. The discount rate represents a measure of the rate of return expected by parties funding the asset being valued.

This method of valuation is appropriate when valuing companies where future cash flow projections can be made with a reasonable degree of confidence.

The capitalisation of future maintainable earnings methodology is generally considered a short form DCF, where an estimation of the Future Maintainable Earnings (“FME”) of the business, rather than a stream of cash flows is capitalised based on an appropriate capitalisation multiple. Multiples are derived from the analysis of transactions involving comparable companies and the trading multiples of comparable companies.

The earnings multiple used in FME valuations must reflect, as a minimum, the risks of the business, the future growth prospects of the business and the time value of money. Different multiples are used for application to different measures of earnings, for example:

  • Profit after tax (“PAT”), also referred to as the Price Earnings Multiple (or PE multiple);
  • Earnings before interest and tax (“EBIT”); or
  • Earnings before interest, tax, depreciation and amortisation (“EBITDA”).

The choice of the earnings measure, and therefore the choice of the multiple, to be used in a valuation should reflect the purpose of the valuation.

Asset Based Methods

Asset based methodologies estimate the fair market value of a company’s securities based on the realisable value of its identifiable net assets. Asset based methods include:

  • orderly realisation of assets method;
  • liquidation of assets method; and
  • net assets on a going concern basis.

The value achievable in an orderly realisation of assets is estimated by determining the net realisable value of the assets of a company which would be distributed to security holders after payment of all liabilities, including realisation costs and taxation charges that arise, assuming the company is wound up in an orderly manner. This technique is particularly appropriate for businesses with relatively high asset values compared to earnings and cash flows.

The liquidation of assets method is similar to the orderly realisation of assets method except the liquidation method assumes that the assets are sold in a shorter time frame, reflecting a distressed liquidation value. The liquidation of assets method will result in a value that is lower than the orderly realisation of assets method, and is appropriate for companies in financial distress or when a company is not valued on a going concern basis.

The net assets on a going concern method estimates the market values of the net assets of a company but unlike the orderly realisation of assets method, it does not take into account realisation costs. Asset based methods are appropriate when companies are not profitable, a significant proportion of the company’s assets are liquid, or for asset holding purposes.

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© RSM Bird Cameron 2014 – Reproduced with permission.

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