Conducting a proper business valuation requires professional judgment, experience, and a working knowledge of various factors. This includes determining the purpose of the valuation, a deep understanding of the industry, value drivers affecting the subject company, economic and competitive factors, and the selection and application of valuation methods and approaches.
Here are some of the fundamentals you should know about business valuation and why it’s important for your business.
1. What Is the Purpose of Undergoing Business Valuation?
Determining the purpose of conducting business valuation is the first vital step in the process. This is because it sets the standard of value or basis of value to be applied and ultimately affects the selection of the inputs, approaches, and assumptions in the valuation. There are many reasons for conducting business valuation, including selling or acquiring the company, litigation and arbitration, insolvency, taxation, financial reporting, transactions, and more. Only when the exact purpose is identified can the proper standard of value be applied. Regardless of the goal, all valuations share specific common attributes. However, differences must be reflected following the standard of value mainly because they could significantly influence the valuation’s outcome.
2. What Standard of Value Should Be Applied?
The standard or basis of value defines the type of value being measured. It also considers the perspectives of the related parties involved in a given transaction. An example would be the standard of value being defined as the value between two willing parties composed of a buyer and seller or as an investment value to a business’s current owner. This is why the value could significantly impact the valuation’s selection of approaches, methods, and assumptions. Often, this is specified by regulation, statute, standard, contract, or other documents per which the valuation is performed. In short, the applicable standard of value and the valuation’s purpose are inextricably linked.
3. Choosing The Premise of Value
The approaches, inputs, and assumptions to be applied in the valuation highly depend on the chosen premise of the value. The purpose of the valuation and standard of value used are the key factors that drive the premise of value, which is generally categorised in the following categories:
- Forced or orderly liquidation premise includes an in-exchange assumption. In other words, assets are sold or operated as a group or individually separate from the existing business.
- Going concern premise presumes that the assets will continue to be used and that the company will remain operational as a business.
4. The Subject of the Valuation
Valuing the common equity or invested capital of a business or its other forms of financial interests requires the application of specific valuation methods or techniques (all of which fall under the 3 main valuation approaches) tailored to reflect their unique terms and attributes. Extra complexities are introduced when a valuation is required to serve as input to perform another valuation.
5. The Business’s Historical Performance
Evaluating a subject company’s performance requires industry benchmarks that serve as a frame of reference relative to its peer groups. It is imperative to understand the business’s past and its evolution, financial measures of historical performance, and owner and management structure regardless of which valuation approach is applied. Margin and growth analyses and financial ratios provide prerequisite historical performance insights.
Historical performance analyses also warrant careful consideration regarding additional factors and items such as non-recurring events and non-operating assets. When valuing a business, the first step involves estimating the value of its operations, followed by including any non-operating assets. As such, valuing and isolating these assets is essential, especially if they are material. Removing non-recurring events leads to a better representative measure of the operations’ indicated future value.
6. What is the Future Outlook for the Business?
Although historical analyses of the company are vital considerations, so are its prospects since businesses derive their value mainly through their potential to create more value in the future. Simply put, value is created when management decides to invest available capital in a way that generates returns that exceed the cost of said capital. Otherwise, if the returns are equal to or below the cost of the capital, the value is eroded at worst, and no value is generated at best.
Assessing a company’s outlook requires a deep understanding of its future investments and expected performance, as well as its ongoing strategy toward maintaining current operations. Furthermore, understanding the expectations regarding the ongoing value creation process is vital to evaluate the business’s future outlook properly. Business expectations with significant deviations from prior performances should raise a high level of scrutiny in the analysis because of the absence of historical reference points.
7. The Main Types of Valuation Approaches
Experts typically adopt the following widely-accepted valuation approaches:
- Market Approach
The market approach utilises prices and relevant information generated from market transactions that involve comparable or identical companies or assets to gauge the value of the business interest or subject business.
- Income Approach
The income approach transforms cash flow or profits into value estimates through capitalisation rates, multiples, and discount rates.
- Cost Approach
The cost approach reflects the amount that would be required currently to replace the service capacity of an asset (referred to as current replacement cost). It assumes fair value would not exceed what it would cost a market participant to acquire or construct a substitute of comparable utility, adjusted for obsolescence.
Valuation of a business is generally a complex process that involves several considerations such as the valuation’s purpose, basis and premise of value applied, and the subject’s past performance and future outlook. Although standard valuation approaches are available, the difficulty lies in choosing the right strategies, developing inputs, properly weighing value conclusions, and using appropriate judgment in making any adjustments.
If you are searching for a professional firm to help you with various business valuation processes, Max Lewis Consultants provides various valuation services you may need throughout your business’s journey. Apart from valuation, we also offer other financial services such as GST Assisted Self Help Kits (ASK), Corporate Secretarial and ERM, and transfer pricing services in Singapore. Make an appointment with us today to start your business’ journey towards global success.
*The above represent our views and opinions and does not necessarily reflect the position of any entities mentioned.