There are a number of methods used to value businesses. How best to value a business will depend on a number of factors.Although financial modeling is essential, it is first critical to consider the market place and transaction strategy from both the perspective of the buyer and seller.The best valuation methodology and price positioning will depend on the marketplace, company size, profitability and nature of the business.Below are the seven most common methods used by CFOs and Corporate Finance teams involved in merger and acquisition (M&A) activities.1) Discounted Cash Flow (DCF) MethodThe DCF method is typically the most robust approach, although generally not applicable to small and medium sized businesses (i.e. businesses with revenue below £25 million).The DCF method attempts to put a value, in today's terms, on future cash flows in an enterprise. The future net cash flows of the business are discounted back to present value.Future cash flows consist of two elements:
In order for DCF to be a robust methodology:
Unfortunately, it is generally not suitable for valuing most other small to medium companies because of the difficulty of estimating cash flows some years into the future, the difficulty of estimating the sale price of the business in the future and the difficulty of assessing a suitable discount rate.2) Internal rate of return (IRR)
IRR has been a popular method, particularly for private equity (PE) firms.
IRR is important to PE firms because they raise money from investors by offering them returns on their investments. If the yield on purchasing a business is too low it makes raising funds from investors difficult. Investors choose funds that have consistently delivered high rates of return.
IRR % = [Future Value / Present Value ]^1/N -1
N= Number of periods e.g. years.
IRR is often not a good basis for decisions and can be misleading.
3) Return On Investment (R.O.I) MethodThis is the most common method used to value businesses worth up to about £5 million. It reflects the percentage returns to an owner on his capital investment in the business.
Return on Investment (R.O.I)
Net profit used in the calculation:
The appropriate R.O.I. is usually linked to the industry, and the best benchmarks are the purchase prices relative to profits of recent deals.Given the R.O.I. for a specific industry (and making adjustment for special features of a particular business), the valuation is arrived at by transposing the above formula.
Goodwill embedded in the price can be derived by subtracting the value of assets purchased from the total purchase price.4) EBITDA MethodMost common method of valuing private businesses worth around £5 million and above.
Value of business = Profit x EBIT(DA) Multiple
Relatively few add-backs are made to the book profit when valuing large businesses as the profit and loss accounts typically reflect running expenses (unlike many smaller businesses). Interest is added back and depreciation in some industries such as technology where significant investment in hardware and development is commonly capitalized and depreciated.The EBIT(DA) multiple to be applied to value a business can vary from around two up to around ten, and sometimes higher, depending upon a number of factors, including:
5) Price to Earnings (P/E) MethodThe P/E method is used to value public companies, and can also be used to value private companies.The P/E method is essentially the same as the EBIT method except that the after-tax profit is used in the calculation and a different ratio is used to compensate for this.The P/E ratio can be calculated based on published public company information. The method requires locating a few public companies similar to the one being valued to obtain an average P/E ratio that can be used as a benchmark for price negotiations.If the business targeted is privately owned, the price is usually discounted anywhere from 50% – 80% per cent to reflect the generally smaller size of the business and the lack of share liquidity compared to public companies. 6) Gross Income Multiple Method
7) Asset Based ValuationThis method is used when other valuation methods give a value that is less than the net tangible assets of a business. Goodwill and intangible assets are not included in the calculation.
The value of fixed and current assets including property, infrastructure investment and other equipment and stock is valued at market value. The asset valuation is based on the concept that a business owner is highly unlikely to sell his business for less than he can receive through sale of the business assets.Stock is initially valued at invoice cost but may be discounted depending upon the amount of slow-moving or obsolete stock.In the case of other assets such as technology infrastructure, the value is likely to be considerably less than book value due to the pace of change in the industry and need to regularly upgrade and replace equipment.https://www.linkedin.com/in/chrisoddyhttps://www.linkedin.com/in/chrisoddy