Business Valuation is a process to estimate economic value of an enterprise or owner’s interest. Valuation is the key requirement for any equity fund raising or business acquisition.
Fair market value is defined as "The price at which property would change hands between a hypothetical able & willing buyer and a hypothetical willing & able seller, acting in arms length in an open & unrestricted market when neither is under any compulsion to buy or sell and when both have reasonable knowledge of the relevant facts"
Business valuation depends upon various influencing factors, which are listed hereunder.
There are mainly three approaches to the valuation namely.
- a. Asset Approach
- b. Market Approach
- c. Income Approach
The Asset approach primarily considers value of net assets owned by an enterprise. These assets could be valued either at present realization price or the cost of replacement or book value.
Liquidation Value of the business represents the net present value of cash flows from liquidating the assets and paying off its liabilities.
Investments are valued at market price.
Net Asset Value represents net equity of the business after assets and liabilities have been adjusted to their fair values arrived by replacement cost or realisation value.
This valuation approach is mainly used in case where the firm is to be liquidated i.e. it does not meet the “going concern” criteria or in case where the assets base dominate earnings capability.
The Asset Approach is generally considered to yield the minimum benchmark of value for an operating enterprise.
The market approach involves identifying comparable companies within the same segment of the industry and uses the comparable financial information to derive valuation using pricing multiples.
The market approach considers valuation of similar enterprise, where transaction happened recently. The information is adjusted for various influencing factors including type of transaction to reflect the specific characteristics of such transaction.
The market approach also considers valuation of similar listed companies. Quoted prices are considered indicative of the perception of investors operating under free market conditions. Under this method, the valuation is done on the basis of share prices of a company quoted on the stock exchange.
Various price multiples such as Revenue, EBIDTA, PAT, Adj EBIDTA are used to arrive valuation of an enterprise. After arriving valuation by using appropriate multiples, deductions are to be applied for specific variance factors and non-marketability.
The income-based approach is the belief that the value of the business must be related to the profits it will earn and the cash it will generate in the future. The two most commonly used methods under this approach are the single period capitalization method and the multiple periods discounting method.
The multiple periods discounted future returns method is more appropriate if the future returns are expected to be substantially different from historical operations. This method usually has two stages, the first stage involves a discreet forecast of future earnings or cash flow to be discounted to the present using a discount rate and the second stage involves the construction & discounting of a terminal value. The terminal value is determined when the entity’s future return stream is expected to achieve stable long-term growth.
The choice of the appropriate valuation approach is determined by the characteristics of the business to be valued, the pattern of historical performance, its earnings trends, the purpose of the valuation, peer’s market position, the availability of reliable information requisite to the valuation method, the marketability of equity ownership and statutory requirements.