What are the Different Methodolgies for Business Valuation?
Banks, lenders and financial institutions all rely upon business appraisals to make important lending decisions. Business valuations can also be used by business owners for their strategic planning, to divide up or sell a business or in divorce and inheritance proceedings. Even so, business valuation is not and absolute, and the results of the exercise will depend upon the methodology used. The methodology itself is chosen with the purpose of the valuation in mind. Hence different techniques, like income, asset and market valuation all produce different kinds of data. Comparables valuation looks at value in comparison to other similar entities.
Choosing a methodology
Business appraisal valuations can be used for many different purposes. They may be used by financial institutions, banks and lenders to make lending decisions. They may be used by business owners to take stock and to chart a path for the future. Business valuation reports may be used when a business is being sold, or if it becomes part of proceedings in legal disputes involving inheritance or divorce.
This is why small business valuations vary. This is not an absolute value, but depends on two elements. These are the standard of value, or how the business value is measured; and the premise of value, or the circumstances under which the valuation is carried out.
Different approaches to business valuation analysis
Business appraisal services use three different approaches to measure the value of a business. These are based on income, assets and market or comparables valuation.
- The income approach measures the value of a business based on its earning power and risk assessment
- The assets approach determines the value of a business based on its assets. This is suitable for asset-intensive businesses and holding companies.
- The markets approach uses comparison with recent sales of similar businesses to determine the value of a business. This uses data from comparable transactions based on NAICS (North American Industry Classification System), revenue or profit size, keyword etc.
Relative equity valuation
Comparables valuation is a relative equity valuation that assumes that the valuation of a business should have some relation to similar enterprises. This can be done using data from key rivals or similar businesses. This approach can be used to determine if the equity is undervalued or overvalued, and corresponding correction can be made.
Comparable approaches can look at market comparables for a firm, such as enterprise value to sales (EV/S), enterprise multiple, price to earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF). Alternatively, they can look at market transactions. In this case, the value of the equity can be determined by comparing it with similar firms that have been bought or acquired.
Business valuation services provide useful data for decision making by banks, lenders and other financial institutions. The value of a business depends on the reasons why the valuation is carried out as well as the methodology used. Comparables valuations measure the value of a firm by comparing it to similar enterprises.