When you’re an entrepreneur, knowing your market and economy becomes important. You need to be learning 24/7 in order to keep growing at a decent pace. There’s no time to wait because the market and economy are changing every second. Business valuation is a skill that every entrepreneur or business person should be aware of. It helps you make smart choices and take calculated risks. So, stick around, there’s a good chance that you’re gonna need it.
To put it in simpler words, business valuation means how much is a business, company or asset is really worth. The skill of business valuation can be really helpful as it can help you invest better and get better results in your business ventures. Now, it is not an exact science, so it has its limitations. But it can be a good estimation strategy to get a good idea of what you’re getting yourself into. The three major strategies that we’ll be discussing are the market approach, the income approach, and the cost approach. Let’s dive a bit deeper to better understand what they really mean.
What is Business Valuation and how it works?
Business valuation is not an exact science. It helps us determine the real value of an asset, company or business. So, the valuation is performed in the context that a generic owner will sell the asset in a hypothetical transaction.
- It is assumed that this hypothetical transaction will occur in the principal advantageous market for the asset (which is a fancy way to say that the asset will be acquired in a market setting where it is most advantageous to make use of it).
- It is assumed that the market participants, both the buyer and the seller are informed and knowledgable about the particular asset.
- And assume that the hypothetical buyer will put the asset to the highest and best, most valuable use.
Fair value is the price of an asset in an orderly transaction between knowledgeable market participants.
- And our hypothetical transaction is the orderly sale is not forced.
- It occurs between two unrelated informed participants.
- Thus, it is not based on the skillset or how the current owner would sell or an exceptional buyer would buy.
- Fair value is based on being accepted to a generic seller and a generic buyer without any particularly special skills or unique handicaps.
Principal market is where an asset is typically traded. If there is no principal market, the asset is put in the most advantageous market to determine the price.
Hence, to sum it all up. The market participants are unrelated and informed, are knowledgeable about the asset, possess the financial resources for the transaction, show interest in the asset and are willing to put it to the highest and best use.
The asset will be sold to the participant who will use it in the most valuable way and the highest price will be paid for the asset. It also depends on the nature of the asset. For example, if we are talking about a share of Microsoft, the best value and the best use of it would be to exchange it when the economy is right. On the other hand, if the asset is in use, like a steel furnace, it is more useful when it is practically being used. When an asset is in use, we assume that the buyer has related assets to maximize the in-use value of the asset.
Difficulties and challenges
There are many difficulties and challenges that are faced by people while determining the value of a business. Business valuation is not an exact science, so, such things are bound to happen at some level. Things like fake data can cause a major problem in business valuation. Misinterpretation of the data is another challenge often faced. Most people don’t know how to interpret the data correctly and it becomes harder and harder as time passes. The businesses that are not public also need more effort and are hard to determine.
Business Valuation Methods
There are three major methods of business valuation. These are
- The market approach
- The cost approach
- And the income approach
The market approach valuation technique uses data from market prices for identical or similar assets. It works well for actively traded public shares on leading stock exchanges. It is difficult to use the market approach when valuing shares for non-public companies.
The cost approach valuation technique is based on the replacement cost of the asset. It is based on the entry price or the cost to buy, not the exit price. Basically, we look at the amount of money needed to buy the exact new version of the asset we want to buy. And then consider the number of years the asset has been in use to determine its value now.
The income approach valuation is based directly or indirectly on Discounted Cash Flow (DCF) analysis. It basically points out the time value of money, which means, money now is worth more than the same amount in the future. So, $100 now is worth more than $100 one year from now. The interest rates allow us to adjust for differences in the time value of money. The interest rate is really important in the DCF analysis. According to this, the more cash flow generated in the future; the more valuable the business. Risky cash flows are worth less than relatively safe future cash flows. Adjust for the riskiness through the choice of an interest rate. For DCF, ask yourself the following three questions
- How large will be the future cash flow?
- When will those cash flows occur?
- How risky are those cash flows?
Risk is a high factor in any kind of overall business development. It is the variability in the potential future outcomes. Liquidity risk is the risk of not being able to sell an investment quickly.
Choosing an appropriate interest rate is important in discounted cash flow (DCF) analysis. In order to get someone to accept more risk, more uncertainty about future outcomes, you need to entice them with higher returns. Higher interest rates expected to be generated by the business.
Pro-forma (projected) financial statement offers all viewpoints of a company’s future financing needs, problems and more. Ask yourself the following questions
- What’s the starting point of any financial statement forecast?
- What causes increases in the company’s assets and liabilities?
- What causes increases in the company’s expenses?
Carefully consider what causes each asset, liability, and expanse to increase when constructing a future cash flow forecast.
What factors increase the reliability of a free cash flow forecast?
- The longer track record
- More detail
- More stable economic environment
It is the valuation technique to identify relevant characteristics and then use market data to determine the price per unit. It is the most preferable way for valuation. Only use DCF when there’s no other way to help the situation. Price multiples are far more accurate.
You shouldn’t rely completely on any valuation technique. Different situations demand different processes of analysis. You can use a hybrid of the most suitable techniques according to your situation.
Can you use this knowledge to excel in the stock market?
This is a question that is bound to come to your head while reading about business valuation. Unfortunately, you can’t use this knowledge to excel in the stock market. If you do it, you’ll lose your money way easier than the effort you put in earning it. It’s not nearly enough. The market shifts and turns really fast. Even if you think you finally got something, you’ll be a couple of weeks too late make use of that information. However, you can use this knowledge to invest in small businesses around the country and the world. It can roughly give you the idea of how much a business is worth. And whether or not should you invest in it.
Secondly, you don’t even have enough data for analyzing. The ones who are really killing it in the stock market are really experienced and skilled set of individuals who have been doing this for years. They have the knowledge and experience with the working of the market and economy which helps them predict future outcomes. They have access to the data that people like you and I don’t. Even they lose too, it often just isn’t made public because their gains are huge too.
So, no, you can’t do that. It’s a long game if you don’t want to wait 30 to 40 years and work your way up to a level that matters, don’t even bother. Just a friendly reminder once again, the answer is still no.