There are several valuation methodologies that can be applied to the valuation of businesses. All are attempts by various parties to find a model that best estimates the value of a business.
Some valuation methods are more accepted within some industries and business types than others. On this basis, it is important that the valuation method used is consistent with:
- What is generally accepted by the courts;
- What is generally accepted by the market, and;
- What is generally accepted by financial institutions.
Below I review 4 of the most common methods used to value a business:
1. Discounted Cash Flow
Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF attempts to work out the value of the business today, based on projections of how much money it will generate in the future. The valuation method assumes that the inherent value of a business is the sum of future free cash flows produced by the business and any terminal value expressed in present value terms.
Discounted Cash Flow is a technically sound valuation method, however its application to the valuation of SMEs can prove challenging as it is often difficult to reliably predict the future cash flows that a SME will generate.
2. Capitalisation of Future Maintainable Earnings
Capitalisation of future maintainable earnings is an income-based method and is one of the most commonly used valuation methods for SMEs. Capitalisation of future maintainable earnings method looks at a business’ financial history, profits and cash flow through reviewing the expected sustainable profits of a business in conjunction with the relevant non-financial risk factors.
3. Net asset backing
The net asset backing method is a very basic business valuation method which calculates the value of the business by finding the difference between the total assets and total liabilities of the business. The asset-based method will provide you with the book value of the business, which reflects the owner’s equity on the balance sheet. This valuation method is often unreliable and impractical, as it only relies on the contents of a business’ financial statement and should only be used as an indicator of the lowest value of the business
4. Comparable Market Transactions
This method of business valuation establishes the value of a business by referencing transaction data from the sale and purchase of similar businesses. The comparable market method values a business at fair market value which reflects what a buyer in the market is willing to pay. In using this method you must ensure:
- The businesses under consideration are reasonably comparable;
- There is a reasonable level of market activity in the sale of these businesses, and;
- The information about the transaction prices is readily available.
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Groves & Partners are expert business transaction advisors and valuers, with significant experience in preparing expert valuation reports for many different purposes while always ensuring that our reports are fit for purpose.