Valuation- Definition, Methods, Reasons and Limitations

Learn what Valuation is, How is it calculated, limitations and reasons for performing a business valuation

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What Is Valuation?

To understand what the word “valuation” means in the context of buying or selling a business, let's break it down into two parts: value and business. Value is an estimate of how much something is worth. A business is a company that makes money by providing goods or services.

So what is valuation? It's an estimate of how much a business is worth.

Though there are many ways to calculate this estimate (which we'll get into later on), the most important thing to remember is that all businesses have value even if they're not up for acquisition.

Why? Because people buy and sell businesses every day, even if those businesses aren't listed on their local equivalent of Craigslist. The act of buying or selling a business doesn't require posting an ad; it just requires that two parties agree on a price and that one party hands over the cash (or gives another form of payment). And while agreeing on a price isn't always easy, people do it all the time because they know precisely what they want from their investment: money coming in from sales now and in the future.

Valuation Methods

The more common methods of valuing a business are:

  • Discounted Cash Flow Method - A valuation method that discounts future cash flows to a present value based on the weighted average cost of capital. The discounted cash flow (DCF) is the sum of all future cash flows over some investment horizon, discounting at a rate that reflects the riskiness of these cash flows. DCF valuation is widely used in investment finance, real estate development, corporate financial management, and patent valuation.
  • Book Value Method - An accounting term that refers to the portion of shareholders' equity reported on a company's balance sheet. It includes the total value of the common stock, the retained earnings, and treasury stocks. It is equal to Total Assets minus Total Liabilities, Preferred Stock and Intangible Assets such as Goodwill. The book value can also be called "Net Asset Value."
  • Market-Based Valuations - A widely popular approach for business appraisers; it involves either finding comparable transactions or going-concerns where sales data was collected from actual market activity or using companies listed publicly on stock markets as comparable firms to derive their current market values by considering multiples such as Price-to-Earnings ratio commonly used for this purpose; otherwise known as Public Comparable Valuation in order to apply them to forecasted or actual financial results derived from an appraisal subject’s financial statements resulting in its implied market capitalization under consideration by investors.
  • Comparable Sales Method - Whereby recent sales data of similar businesses are analyzed in order to derive relevant benchmark(s). These benchmarks may then be applied either directly or indirectly (using multiples) against an appraisal subject’s own financial results leading up to its implied enterprise value-seeking fair market value determination by appraisers.

How Earnings Affect Valuation

Earnings are a crucial part of a company's valuation. They represent the profit generated by a business over time and are used to calculate many valuation metrics, including price-to-earnings ratio (P/E) and earnings per share (EPS). A higher level of earnings will usually result in a higher valuation for a business. In addition, an upward trend in profits can cause an increase in the value.

A number of factors affect the level of earnings that a business generates over time. The macroeconomic environment—including the industry, location, and size of the market—can influence sales volume and profit margins which, when combined together with expenses like labor costs or interest payments on debt, determine profits. Management effectiveness is also important because it can reduce operating costs while increasing productivity or sales volume through strategic planning and operational excellence.

Limitations

The limitations of valuation analysis arise because it is not an exact science. Valuations depend on the assumptions made, and they can vary significantly depending on the analyst. A valuation is only as good as the information you put into it, and this is where some investors can be led astray by valuations that are too optimistic or pessimistic.

This doesn't mean that valuation analysis should be discarded in favor of other investment strategies. While a single analyst's work might not provide all the information you need, there are plenty of analysts working at banks and stockbroking firms who perform valuations for a living. The trick (as with any investment strategy) is to use valuations as one part of your overall investment due diligence process rather than relying on them exclusively.

Reasons for Performing a Business Valuation

You might consider having a business valued if:

  • You're selling a business. If you or the owner are getting ready to sell the company, it's important to know the fair market value of the business before negotiating a price with a buyer. Obtaining an independent valuation can help prevent any future disputes between you and your buyer and ensure that both parties are in agreement on how much the company is worth.
  • You're buying a business. A formal valuation can also be helpful to buyers looking to purchase a new company by offering assurance that they aren't overpaying for what they are buying. This can also help mitigate any conflicts over pricing after the sale has closed and protect their investment from unforeseen risks associated with undervalued companies.
  • You're raising capital for your company, either through debt or equity financing, or both. It's important for potential investors to have an independent assessment of what your company is worth so that they know whether it's worth investing in at all and how much money it may be able to generate down the road.

Conclusion

A valuation is an estimate of the value of a business. Although valuations rely heavily - if not exclusively - on information supplied by management and third parties, this data may not present a full picture of the company's condition or performance potential.

The process of business valuation is useful for many reasons. The value of a business is often used in the sale or transfer of a business, to determine the capitalization rate for a closely held corporation that must be valued for estate and gift tax purposes, to determine the fair market value for employee stock ownership plans (ESOPs) and in other instances.

There are limitations to any attempt at business valuation: The future is unpredictable. Many economists base their financial projections on past trends; however, factors such as changes in management, technology, industry trends, and government regulations can have a significant impact on a company's ability to compete successfully.

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