VALUATION CONCEPTS AND METHODS COURSE OUTLINE

1. INTRODUCTION

Value
The monetary worth of an asset, business entity, goods sold, services rendered, or liability or
obligation acquired

What is Value?
In accounting terms, value is the monetary worth of an asset, business entity, goods sold, services
rendered, or liability or obligation acquired. In economic terms, value is the sum of all the benefits
and rights arising from ownership.

Economic Value
The economic value of a business is the business’s contribution to the global gross domestic product
(GDP). The most common method of estimating economic value is the counter-factual method. The
counter-factual method states that the economic value of a business is the difference between the
current global GDP and the hypothetical global GDP if the business did not exist.

Value vs. Price

The value of a business is usually derived through discounted cash flow (DCF) analysis. They are
mathematical models that provide a valuation of a company by estimating and then appropriately
discounting future incomes earned. DCF analysis provides an estimate of how much revenue the
business is expected to earn over its lifetime.

The value per share of a company can be calculated by simply dividing the value by shares
outstanding. When valuing a business, an analyst is trying to answer the following question: How
much is this business worth in the market? Accountants tend to focus on stock valuations and
consider owners’ equity as the most accurate estimator of the true value of a business.

On the other hand, financial markets investors tend to focus on flow values and consider net revenues
as the most accurate estimator of a business’ true value. The market price of a business is the
market’s estimate of the true value of the company. Since the market is composed of heterogeneous
agents with rapidly changing beliefs about the business, the market price of a business fluctuates
drastically (to reflect the changing beliefs).

In addition, the business’ market price is also affected by the state of the overall economy. It may
increase during an economic boom (expansionary phase) and decrease during a recession
(contractionary phase).

Key Principles of Business Valuation

The following are the key principles of business valuation that business owners who want to create
value in their business must know.

1. The value of a business is defined only at a specific point in time.

The value of a privately-held business usually experiences changes every single day. The earnings,
cash position, working capital, and market conditions of a business are always changing. The valuation
prepared by business owners a few months or years ago may not reflect the true current value of the
business.
The value of a business requires consistent and regular monitoring. This valuation principle helps
business owners to understand the significance of the date of valuation in the process of business
valuation.

2. Value primarily varies in accordance with the capacity of a business to generate future cash flow
A company’s valuation is essentially a function of its future cash flow except in rare situations where
net asset liquidation leads to a higher value. The first key takeaway in the second principle is “future.”
It implies that historical results of the company’s earnings before the date of valuation are useful in
predicting the future results of the business under certain conditions.
The second key in this principle is “cash flow.” It is because cash flow, which takes into account capital
expenditures, working capital changes, and taxes, is the true determinant of business value. Business
owners should aim at building a comprehensive estimate of future cash flows for their companies.
Even though making estimates is a subjective undertaking, it is vital that the value of the business is
validated. Reliable historical information will help in supporting the assumptions that the forecasts
will use.

3. The market commands what the proper rate of return for acquirers is
Market forces are usually in a state of flux, and they guide the rate of return that is needed by
potential buyers in a particular marketplace. Some of the market forces include the type of industry,
financial costs, and the general economic conditions.
Market rates of return offer significant benchmark indicators at a specific point in time. They influence
the rates of return wanted by individual company buyers over the long term. Business owners need to
be wary of the market forces in order to know the right time to exit that will maximize value.

4. The value of a business may be impacted by underlying net tangible assets

This principle of business valuation measures of the relationship between the operational value of a
company and its net tangible value. Theoretically, a company with a higher underlying net tangible
asset value has higher going concern value. It is due to the availability of more security to finance the
acquisition and lower risk of investment since there are more assets to be liquidated in case of
bankruptcy.
Business owners need to build an asset base. For industries that are not capital intensive, the owners
need to find means to support the valuation of their goodwill.

5. Value is influenced by transferability of future cash flows

How transferable the cash flows of the business are to a potential acquirer will impact the value of
the company. Valuable businesses usually operate without the control of the owner. If the business
owner exerts a huge control over the delivery of service, revenue growth, maintenance of customer
relationships, etc., then the owner will secure the goodwill and not the business. Such a kind of
personal goodwill provides very little or no commercial value and is not transferable.
In such a case, the total value of the business to an acquirer may be limited to the value of the
company’s tangible assets in case the business owner does not want to stay. Business owners need to
build a strong management team so that the business is capable of running efficiently even if they left
the company for a long period of time. They can build a stronger and better management team
through enhanced corporate alignment, training, and even through hiring.

6. Value is impacted by liquidity

This principle functions based on the theory of demand and supply. If the marketplace has many
potential buyers, but there are a few quality acquisition targets, there will be a rise in valuation
multiples and vice versa. In both open market and notional valuation contexts, more business interest
liquidity translates into more business interest value.
Business owners need to get the best potential purchasers to the negotiating table to maximize price.
It can be achieved through a controlled auction process.

The above are fundamental business valuation principles that determine the value of a business. The
value of any business is usually determined at a specific point in time and is impacted by the
company’s capacity to generate future cash flow, market forces, underlying net tangible assets,
transferability of future cash flows, and liquidity.

Although they are technical valuation concepts, the basics of the valuation principles need to
understood by business owners to help them increase the valuation of their businesses.
Valuation Methods
The main methods used to value a business

What are the Main Valuation Methods?

When valuing a company as a going concern, there are three main valuation methods used by
industry practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent
transactions. These are the most common methods of valuation used in investment banking, equity
research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts
(LBO), and most areas of finance.

Method 1: Comparable Analysis (“Comps”)

Comparable company analysis (also called “trading multiples” or “peer group analysis” or “equity
comps” or “public market multiples”) is a relative valuation method in which you compare the current
value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or
other ratios. Multiples of EBITDA are the most common valuation method.

The “comps” valuation method provides an observable value for the business, based on what other
comparable companies are currently worth. Comps are the most widely used approach, as they are
easy to calculate and always current. The logic follows that if company X trades at a 10-times P/E
ratio, and company Y has earnings of $2.50 per share, company Y’s stock must be worth $25.00 per
share (assuming the companies have similar attributes).

Method 2: Precedent Transactions

Precedent transactions analysis is another form of relative valuation where you compare the
company in question to other businesses that have recently been sold or acquired in the same
industry. These transaction values include the take-over premium included in the price for which they
were acquired.

The values represent the en bloc value of a business. They are useful for M&A transactions but can
easily become stale-dated and no longer reflective of the current market as time passes. They are less
commonly used than Comps or market trading multiples.

Method 3: DCF Analysis

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the
business’ unlevered free cash flow into the future and discounts it back to today at the firm’s
Weighted Average Cost of Capital (WACC).

A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of
detail and analysis. It is the most detailed of the three approaches and requires the most estimates
and assumptions. However, the effort required for preparing a DCF model will also often result in the
most accurate valuation. A DCF model allows the analyst to forecast value based on different
scenarios and even perform a sensitivity analysis.

For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different
business units are modeled individually and added together.

Other Valuation Methods

The cost approach, which is not as commonly used in corporate finance, looks at what it actually costs
or would cost to rebuild the business. This approach ignores any value creation or cash flow
generation and only looks at things through the lens of “cost = value.”

Another valuation method for a company that is a going concern is called the ability to pay analysis.
This approach looks at the maximum price an acquirer can pay for a business while still hitting some
target. For example, if a private equity firm needs to hit a hurdle rate of 30%, what is the maximum
price it can pay for the business?
If the company does not continue to operate, then a liquidation value will be estimated based on
breaking up and selling the company’s assets. This value is usually very discounted as it assumes the
assets will be sold as quickly as possible to any buyer.

Enterprise Value vs Equity Value

The enterprise value is the entire value of the business, without giving consideration to its capital
structure, and equity value is the total value of a business that is attributable to the shareholders.

The enterprise value (which can also be called firm value or asset value) is the total value of the assets
of the business (excluding cash).

The equity value (or net asset value) is the value that remains for the shareholders after any debts
have been paid off.

Enterprise value is more commonly used in valuation techniques as it makes companies more
comparable by removing their capital structure from the equation.