Chapter 6 Steps to Establish the Business Worth – CS Professional Valuations and Business Modelling Study Material is designed strictly as per the latest syllabus and exam pattern.
Steps to Establish the Business Worth – CS Professional Valuations and Business Modelling Study Material
Question 1.
Explain the steps to establish the business worth of a company?
Answer:
Steps to Establish Business Worth
Business valuation is a process that follows a number of key steps starting with the definition of the task at hand and leading to the business value conclusion. The five steps are:
- Planning and preparation
- Adjusting the financial statements
- Choosing the business valuation methods
- Applying the selected valuation methods
- Reaching the business value conclusion
Step 1: Planning and Preparation
A successful business takes planning in a disciplined manner as effective business valuation; effective business valuation requires organisation of significant facts and focusing on business related matters in detail. The two key starting points toward establishing your business worth are:
- determining why you need business valuation
- assembling all the required information
It may seem surprising at first that the valuation results are influenced by need for a business valuation. Business valuation is a process of measuring business worth and this process depends on two key elements: how you measure business value and under what circumstances.
In formal terms, these elements are known as the standard of value and the premise of value. Business value depends on how and why it’s measured.
Step 2: Adjusting the Historical Financial Statements Business valuation is largely an economic analysis exercise. Not surprisingly, the company’s financial information provides key inputs into the process. The two main financial statements you need for business valuation are the income statement and the balance sheet. To do a proper job of valuing a small business, you should have 3-5 years of historic income statements and balance sheets available.
Many small business owners manage their businesses to reduce taxable income. Yet when it comes to valuing the business, an accurate demonstration of the full business earning potential is essential.
Since business owners have considerable discretion in how they use the business assets as well as what income and expenses they recognize, the company’s historical financial statements may need to be recast or adjusted. The idea is to construct an accurate relationship between the required business assets, expenses and the levels of business income these assets are capable of producing. In general, both the balance sheet and the income statement require recasting in order to generate inputs for use in business valuation. Here are the most common adjustments:
- Recasting the Income Statement.
- Recasting the Balance Sheet
Step 3: Choosing the Business Valuation Methods
Once your data is prepared, it is time to choose the business valuation procedures. Since there are a number of well-established methods to determine business value, it is a good idea to use several of them to cross-check your results.
All known business valuation methods fall under one or more of these t fundamental approaches:
- Asset approach
- Market approach
- Income approach
Step 4: Number Crunching: Applying the Selected Business Valuation Methods
With the relevant data assembled and your choices of the business valuation methods made, calculating your business value should produce accurate and easily justifiable results.
One reason to use several business valuation methods is to cross-check your assumptions. For example, if one business valuation method produces surprisingly different results, you could review the inputs and consider if anything has been overlooked.
Business valuation software tools must assist business people with making critical decisions, while performing routine calculations automatically. Here are the key elements that set apart quality business valuation software products:
1. Ease of use
Business valuation software that makes your life easier integrates a number of tools and resources into one easy-to-use package. You should have ready access to the tools you need and help on how to use them.
2. Power
Business valuation software should support a number of standard business valuation methods. Your tools must help you focus on the “big picture” of measuring your business worth – handling all the math details for you.
business valuation using a number of methods under the market, income, and asset business valuation approaches. No one method is better than another.
3. Flexibility
You can do your business valuation using a number of methods under the market, income, and asset business valuation approaches. No one method is better than another.
4. Extensive help system
If you are new to business valuation, understanding the right terms and concepts is very important. To save you time, your business valuation software Help System should provide you with a quick reference to the term definitions, explanations and examples of the tools.
The system should act as your Information Center by offering suggestions on how to calculate and interpret your business valuation results.
5. Accuracy of business valuation calculations
Needless to say, the credibility of your business appraisal relies upon the accuracy of your results. Business valuation software should offer you a choice of well-designed, standard business valuation methods.
6. Security of critical business data and your computer systems Business valuation involves analysis of sensitive business data. Your business valuation software should safeguard privacy and security of this data and support its communication to the right people.
7. Cost of ownership
State-of-the-art business valuation software should help you measure your business value – without breaking the bank.
Modern technologies, such as Open Source, help make your business valuation software far more powerful and cost-effective when compared to older proprietary systems.
Step 5: Reaching the Business Value Conclusion Finally, with the results from the selected valuation methods available, you can make the decision of what the business is worth. This is called the business value synthesis. Since no one valuation method provides the definitive answer, you may decide to use several results from the various methods to form your opinion of what the business is worth.
Step 6: Number Crunching: Applying the Selected Business Valuation Methods
How can we find Terminal Value?
Terminal value is found either by using the relative valuation or the DCF method. Tata Steel had used DCF method to calculate the Terminal Value. The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has the mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity). The formula for calculating the terminal value is:
The formula for calculating the terminal value is:
TV = (FCFn × (1 + g)) / (WACC – g)
Where:
TV = terminal value
FCF = free cash flow
g = perpetual growth rate of FCF
WACC = weighted average cost of capital
Step 7: Reaching the Business Value Conclusion Analysts value a company for various reasons. They value a company to determine if its stock is undervalued or not. Acquiring companies value target companies to determine the acquisition premium that can be paid to the shareholders of the target companies.
Valuation of stocks or companies is a useful exercise for primarily three types of people.
- It helps medium to long term investors in deciding whether a stock is properly priced in the market.
- Valuation of the target company is a necessary input for the acquiring company, irrespective of whether the merger is financed with cash or stock.
- Valuation Techniques can help us assess the impact of any corporate decision like corporate restructuring, share buyback, etc., on the stock price of the company.
This proves to be a useful tool for corporate finance executives in the company and valuation consultants.
Question 2.
Explain the methods of Business Valuation?
Answer:
Asset Approach
Under the asset approach you adopt the view of a business as a set of assets and liabilities. The balance sheet elements serve as building blocks to create the picture of business value. A finance professor would tell you that the asset approach is based on the economic principle of substitution.
Choosing the asset based business valuation methods
Determining the value of an asset-rich company may justify the cost and complexity of the asset-based valuation methods, such as the asset accumulation method. In addition to valuing the individual business assets and liabilities, the method can be helpful when allocating the business purchase price across the individual business assets, as part of the asset purchase agreement.
However, the method requires considerable skill in individual asset and liability valuation which often makes its application costly and time consuming.
Business Value = Assets + Business Goodwill
Market Approach
Under the market approach, you look for signs from the real market place to figure out what a business is worth. The market is a competitive place, so the economic principle of competition applies:
What are other businesses worth that are similar to my business?
Key uses of market-based business valuation
Determining your business value by such market comparisons is especially useful in these situations:
- To set an asking price or offer price for a business acquisition.
- To defend your business valuation in a legal controversy or before the tax authorities.
- To justify your business value in a dispute such as partner disagreements or buyout.
Business fair market value estimation
Market comparisons are an excellent way to estimate the very important fair market value of a business. This is by far the most common measure of business value – and is the de-facto standard used in most business valuations.
Valuation Multiples: business value calculation
You can use a number of valuation multiples to estimate your business fair market value. All such multiples are statistically derived ratios that relate the potential business selling price to some measure of its financial performance. Using the valuation multiples derived from comparable business sales, you can determine what your business is worth based on its recent revenues, net income, discretionary cash flow, EBITDA, total assets or book value, among others.
The Income Based Business Valuation
Income based business valuation methods determine business worth based on the business earning power. Business valuation experts widely consider these methods to be the most accurate. All income-based business valuation methods rely on either discounting or capitalization of some measure of business earnings.
The discounting methods, such as the Discounted Cash Flow, produce very accurate results by letting you specify the details of the expected business income stream over time. The Discounted Cash Flow method is an excellent choice for valuing a young or rapidly growing company whose earnings vary considerably.
Alternatively, the so-called direct capitalization methods, such as the ValueAdder Multiple of Discretionary Earnings, determine your business worth based on the business earnings and a carefully constructed capitalization rate. The Multiple of Discretionary Earnings method is an outstanding choice for valuing small established companies with consistent earnings and growth rates.
The income valuation approach helps you to figure what kind of money the business is likely to bring as well as to assess the risk.
Business valuation by income capitalization
The capitalization valuation method is essentially the result of dividing the expected business earnings by what is known as the capitalization rate. The idea is that the business value is defined by business earnings and the / capitalization rate is used to relate the two.
For example, if the capitalization rate is 33%, then the business is worth f about 3 times its annual earnings. An alternative is a capitalization factor that is used to multiply the income. Either way, the result is what the business value is today.
The capitalization method works really well for businesses with steady, predictable earnings. Nothing like a cash cow business to cut you a handsome paycheck every month.
Valuation of a business by discounting its cash flow
In the discounting valuation method, first, you forecast the business income some time into the future, usually a number of years. Next, you figure out the discount rate which captures the risk of getting this income on time and in full measure.
Finally, you estimate what the business is likely to be worth at the end of your forecast period. If you expect the company to keep running, there is some residual value, also known as the terminal value. Discounting the forecast earnings and the terminal value together gives you the present value of the business, or what it is worth today.
Question 3.
How can the company find the terminal value and what is the usage of terminal value?
Answer:
Terminal value is found either by using the relative valuation or the DCF method. Tata Steel had used DCF method to calculate the Terminal Value. The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has the mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity). The formula for calculating the terminal value is:
The formula for calculating the terminal value is:
TV = (FCFn × (1 + g)) / (WACC – g)
Where:
TV = terminal value
FCF = free cash flow
g = perpetual growth rate of FCF
WACC = weighted average cost of capital