Valuation Methods

There are different methods to value a business and the use of each method depends on the purpose of the valuation. The most common ways used are:

Market comparison method

A widely used approach to value a business or shares in a company is to compare the business to similar ones in the market. This usually requires either comparisons to such businesses sold and the values reflected in the transaction price or similar listed businesses which have shares being traded in the market (market share price). With each of these approaches the main information is the earnings multiples or ratios reflected in the price. A multiple or ratio is simply the ‘multiplication factor’ which was applied to the earnings of the business to arrive at a value.

Earnings to which multiples are applied usually include Turnover, Earnings per share (Profit after tax per share) Earnings before interest and tax (EBIT) or Earnings before interest tax and depreciation (EBITDA).

However the above methods do reflect the treatment of debt. Remember, the treatment of debt is vital to arrive at the correct valuation and the articles on enterprise value and equity value explain how to treat debt when valuing a business.

Cash flow method

Cash is the fundamental benefit to engaging in any business activity and the cash generated from the business would typically represent the worth of the business. The most common approach used to do this is the Discounted Cash Flow (DCF) method which the sum of the present value of future cash flows generated from the business. In order to do a DCF valuation, the anticipated future cash flows from the business would need to estimated over the expected life of the business and would need to be discounted by a applying a suitable discount rate to the stream of cash flows.

Dividend yield method

This is method is suited to valuing a shareholding in a company. The concept here is similar to the above as it takes into account the cash or dividend income which is derived from holding the shares. However, this is more suited for use when you are valuing a small shareholding (less than 25%: significant holding level) in a company as dividends paid do not include any premium for controlling or having a significant influence in a company.

Asset based valuation

For a business which is primarily made up of assets (eg: property company) an asset based approach is more suited as the commercial value of the assets would represent most of the value of the business. The net book value on the balance sheet or independent valuation of property using chartered surveyors would be a reasonable valuation. However, a business which is in liquidation would need to recover as much money as it can for its debt and equity holders and the book value of the individual assets would be the ‘break up’ value of the business. The net book value would be used as a starting point to value the business.