Are you thinking about buying or selling a company? In today’s world where mergers and acquisitions have become so frequent, valuation process plays a fundamental role in determining the best estimate value for a business given all its counterparts. It is always advantageous to understand the intricacies of the valuation methods which we are going to cover in this article, the prominent benefit would be understanding the intrinsic value of a business. It is essential to accurately calculate the value of your business especially when you are selling your business as this will give you a clear idea on what price to expect from a buyer.
Following are some of the factors that can affect the value of a business:
- Financial aspects such as historical and projected profit, cash flow and costs.
- How much are your competitors worth?
- State of the economy
- Customer Relationships
- Orders/purchases in hand
- Key employees
- Goodwill of the company and brand name
- Patents or IPR that you might hold
- Value of assets and debt
- Promotion and marketing activities
The most important factor is how much a buyer is ready to pay for your business. All the above factors will influence the price buyers want to pay. Therefore, it is advisable to not over-value your business as this can put off the potential buyers or investors.
Effects of COVID-19 on Value of your company:
Entrepreneurs wonder how much the value of their company has changed with the COVID-19 crisis. We must first distinguish the companies that have the financial capacity to withstand this crisis from those that will have to be sold to avoid bankruptcy.
In case of the former, buyers know that this virus has run amok in the balance sheets and profit and loss accounts of almost all companies: their supply chain is deteriorated, inventories are out of balance, there are production stoppages or delays, it is difficult to sell or collect, etc. As this is a common issue for all companies, they will not take what happened in 2020 as a basis for their assessments.
In the latter, the objective of valuation loses relevance because what matters is to save the company, the jobs, and the patrimonial responsibilities of the partners. In these cases, the saying makes sense: the value of the company is determined by the problem that is solved by its sale.
So how much your company is worth in a COVID-19 environment?
If we follow the events of China, 80% of their production is normalized and businesses have started operations. The buying and selling of companies have also been activated. This means that, if in a few months the situation returns to normal, the year 2020 will be remembered as a nightmare for everyone, and to assess valuation, the previous years will be taken as a reference together with the forecasts for 2021 and subsequent years. The results of 2020 will be treated as an abnormal circumstance and will hardly weigh on the assessment.
When we value a company, we must choose the method that best suits the objective of the valuation: it is not the same to assess this to know the intrinsic value of the company to determine the value to prepare a negotiation. We must distinguish between price and value, since in a company acquisition, the price is only known on the day the deed is signed (sometimes not even then), and until that date, everything is negotiation.
A price of a company is a specific value of a company materialized at the moment of sale and depending up on the supply and demand of the market at that moment. A value of a company is what every potential buyer gives a company depending upon his profile and interests. It is the monetary measure of how useful the company is going to be for that person.
One element that buyers should consider in a COVID-19 valuation is the risks of loss of significant contracts or regulatory changes, but these risks will be cleared during 2021. The evaluator should make an analysis of expectations about the future situation of the economy and the sector, based on what he knows or can know at the time of the valuation.
Before addressing any of the valuating methods, all the company’s past and present financial data must be accurate. Only this way, and consistent with the strategic approach, will you be able to make a reliable projection of said data and reach realistic conclusions about the company’s value.
There are three primary valuation approaches which will help you to estimate actual value of the business:
- Market based approach
- Asset based approach
- Income based approach
Market Based Approach:
This method has unique advantages as it is faster, simpler and practical however, may turn out to be far from reality if conducted incorrectly. Under this approach you need to:
- Identify a comparable company which is in same industry and in similar line of business or market.
- Identify a suitable multiple to be used
- Select an appropriate variable and multiply
Following are some of the common multiples that you can use:a) Price/Earnings (P/E): In this we multiply the profit after tax to arrive at an estimate of equity value. Though this is the most easy and widely used method, the main concern is using the PAT which can be affected by a number of accounting adjustments and distorted by capital structure. Also a consistent track of profits is needed to make sense.
b) Price/Sales (P/S): In comparison to above, this method is less manipulated, easy to calculate and not influenced by the capital structure. It is also useful for companies which don’t have consistent profits and more appropriate for some sectors like retail.
c) Price/Book Value (P/BV): Under this method, we use a multiple that is applied to the book value or accounting value of net assets of the company. This is particularly relevant for sectors where revenue is directly dependent on the value of assets such as banking.
d) EV/EBITDA: Earnings before interest, taxes, depreciation and amortization is widely preferred by the analysts as it removes the effects of all the distortions such as capital structure, different tax rates, and non-operating income. Since EBITDA is earnings before interest, the appropriate value to be placed in numerator would be Enterprise value or value of debt plus value of equity plus cash balance.
Asset Based Approach:
The Net Asset Value (NAV) method is the easiest way to determine the value of your company. It is calculated simply by adding up fair value of all assets minus the debt or external liabilities. The important point here is to ascertain the fair value, especially off assets since their fair value may differ from acquisition value (for non-depreciating assets) and recorded value (for depreciating assets). It is possible that true value of your company may be higher than the total value of the assets as things for which you never paid may form part of the value and also the unique way of doing the business which gives your company a competitive advantage. Replacement Cost Method which can be said as an extension of NAV provides relief from some of these issues. In simple terms, it is the value that a rational person is ready to pay to set up a business that is exactly same.
Income Based Approach:
This primarily involves computing the value of the company using Discounted Cash Flow (DCF). The objective behind this method is to determine the company’s ability to generate wealth, estimating the money that the owners will be able to take home with them during the lifespan of the company. Under this method we convert these future cash flows into today’s currency by using a ‘discount rate’ to reflect future money’s value discounted to today’s value including the potential risk associated with the said generation of the wealth. In simple terms, this method provides an insight into the future performance of the company and its ability to generate the cash flow via company’s resources. DCF requires analysis of the historical data and also market and competitive positioning analysis. After these preliminary analyses are completed, the cash flow can be estimated – this will be an estimate of the future cash that a shareholder can take home without damaging the growth of the company, consequently for a period of time. Normally this time period ranges from 4 – 5 years as after that estimating the accurate value will become complicated. Because of this the buyers generally estimate projections for a shorter period than sellers. Most important point here to remember is that the future cash flows must be discounted to a discount rate because the value of money today is not the same as it will be in the future.
Conclusion:
Basically, the valuation process is a preliminary task to sell your company. It often provides an insight into the important areas of a business that allows owners to leverage the advantages and focus on improving the weaknesses. This valuation provides an accurate estimation of the value range that both parties of the deal can use as the backbone of the negotiations. It is important to understand that there is no fixed formula or perfect valuation method for each situation, but on the basis of company’s characteristics and its corresponding environment, the appropriate method can be selected from the variety. The business valuation is an absolutely essential process to be able to maximize the price of the company backed by logical reasoning and numerical arguments. If you are looking for an expert to assist you with the valuation process then we will be happy to work with on same.
