What does Business Valuation mean?
Business valuation refers to a process and a set of procedures applied to estimate the economic value of an owner’s interest in a business organization. Business valuation is used by financial market participants (most notably investment banks and high net worth investors) to evaluate the price investors are willing to buy or sell for the underlying business. In addition to estimating the selling price of the underlying business, business valuation tools are typically used by business appraisers to resolve disputes related to gift and estate taxation, as well as divorce litigation and establishing a formula for observing the value of partners’ ownership interested for buy-sell agreement contracts.
Elements of the Business Valuation Process:
Before a business can be properly analyzed and measured, the valuation assignment must specify the reason surrounding the business valuation. Once the reasons are stated, the business valuation process will initiate a description of national, regional and local economic conditions at the time of the valuation date. The business valuation process begins with an analysis of the underling businesses’ key economic variables.
A common source of such information is found in the Federal Reserve Broad’s Beige Book, which will list all pertinent statistics and measures associated with the business.
When the information is obtained the business valuation process calls for the undertaking of financial analysis. This process typically involves common size analysis, ratio analysis (evaluation of the firm’s turnover, liquidity, profitability, etc.), industry comparative analysis and trend analysis. Evaluating these statistics enables an analyst to compare the underlying company to other businesses in the same industry and to reveal trends, which ultimately affect the company, or industry as a whole, over time.
In addition to comparing the company with a competitor, the analyst will evaluate the company’s financial statements in different time periods. By doing so, the analyst can forecast and in growth or decline in profits or expenses, changes in capital structure and other financial trends. By analyzing these statistics, the business valuation process can assess the subject company’s level of risk, while, determining the selection of market multiples and the discount rate.
Approaches to Evaluating a Business:
There are three different approaches commonly used in business valuation: the income approach, the market approach and the asset-based approach. Within each of these approaches, there are numerous techniques used for determining the value of a business. In most cases, the income approach is used to determine value by calculating the net present value generated by the business, while the asset-based approaches determine value by adding the sum of the business (net asset value). Lastly, the market approach determines value through a comparison of the subject company to other companies in a similar industry or geographic location.