Sunday, 18 April 2010

Estimate the value of a business

The ultimate measure of a business's cumulative success is its value.

Valuing a business is an art, and there are a number of different techniques, which may produce different valuations for the same business.

Discounted cash flows (DCF)

Valuation = present value of estimated future cash flows.

Arguably, this is the most accurate method of valuation, but it relies on access to information and the quality of the estimations used.

Income multiples

Valuation = 'income' x multiple

Price/earnings (P/E) ratios are valuation multiples for publicly listed companies.  The long-term average P/E multiple for listed companies is around 15.  This means that valuation are on average 15 times earnings (or profits).  Note that P/E ratios vary widely with the economy and across companies, industries and countries.

Unlisted business can use a reduced P/E ratio from a similar listed company, for an approximate valuation.  The reduction should reflect the difference in selling private versus public company shares.

Revenue multiples are an alternative to earnings multiples and use a price/sales ratio.  They are useful for businesses with fluctuating profits or even losses, as revenue should be more stable.

Asset based valuations

Valuation = net assets value

This method is a useful minimum benchmark of a business's value.  The value of net assets in the balance sheet is often based on historic costs, which do not fully reflect the future growth potential of a business.

Valuing a business for sale

Valuations are rarely the actual price paid by a buyer in the event of a business sale.  The range of values are used by buyers and sellers of businesses simply as a starring point for negotiations.  Other factors affecting value are as follows:
  • The strategic reasons for buying or selling
  • The number of competing buyers and sellers
  • The negotiation skills of both buyers and sellers
  • The state of the economy
  • If the purchase price is paid in cash or in shares.
  • The views of different owners - if they all agree to the sale.
  • If the valuation is for the whole or part of a business.

Essentially, a business is worth what someone is willing to pay for it!

Related posts:

Measuring Business Performance

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