Business Valuation made easy

How do you place a value on how much your business start-up is worth? Recently, an entrepreneur who has been running his own magazine and wanted to sell it asked me how he should value the business. Valuation of business is fairly simple if you have been recording your revenues, expenses and cash flows in a systematic manner.  In that case you can simply use one of the valuation techniques in a straightforward manner.

Usually, any good method of valuation should take into account the future benefits and costs that are likely to accrue from the business, as the business assumes the ‘going concern entity’ concept. As per this principle, a company is to continue to operate indefinitely, and will not go out of business and liquidate its assets. The going concern principle is closely related to valuation, especially to the practice of recording your assets at ‘historical cost’ or the cost paid to initially acquire these assets, and not the market value of the asset. For example, if a company purchases fixed assets were Rs. 2 million, but their market value changes to Rs. 4 million, the balance sheet should continue to show this at acquisition cost of Rs. 2 million. Any charges of installation or bringing the asset to use also form part of the initial, historical cost.

Historical valuation is based on the assumption of going concern. What this essentially means is that when you are acquiring an asset, it is assumed that the asset will produce income and will not be sold off. The firm will continue to exist and make full benefit of these assets hence, the selling price or the market value of the asset is not significant for a going concern. Thus, there are relatively simple ways of valuing parts of a business, such as assets or liabilities; valuation of the business can be much more complex especially due to the presence of intangible assets such as goodwill. Valuation of goodwill generated by the business can be based on average profits, super profits that are over and above normal profits or by capitalization of earnings. TO value your business in its entirety, it is important to understand certain terms and methods, given below:

  1. Earnings Multiplier or P/E Ratio: P/E ratio represents the value of the business divided by its post tax profits. If you have the P/E multiplier for your industry, you can simply multiply it by your post tax profits and obtain the value of your business. If you are considering a merger with another firm, the P/E ratio is simply the weighted average of the two respective ratios, with weights being the share of earnings in the combined entity.
  2. Discounted Cashflows Technique: This is the most commonly used technique. It is based on the concept of time value of money. The worth of one rupee today will be less in future due to various factors such as preference for current consumption, risk associated with future payments, inflation, etc. Thus, what this method does is to first estimate the company’s cash-flow over a certain period of time and also the ‘terminal value’ of the company at the end of this period based on salvage value of assets, recovery of working capital, etc. Now the total value is discounted for its present value using the appropriate discounting rate of return. For this method to give a precise value, estimation of cash-flows over the future should be done carefully. This valuation method is best suited for cases where a company has a lot of future potential but little financial history.
  3. Key indicators such as NPV, MIRR, ROI and EVA Calculation: These indicators give a fair idea of how much the firm is worth.
  • NPV or the Net Present Value uses the discounting cash-flows technique and is calculated as the present value of cash inflows less the present cash outflow.
  • Another indicator called IRR or the internal rate of return can be calculated to show that rate of interest at which NPV is zero. However, this method makes the assumption that all earnings are reinvested at the IRR itself, which may not always hold true. As an improvement over this method, one can use MIRR or the Modified Internal Rate of Return, which assumes that positive cash flows are reinvested at the firm’s cost of capital. It is a more accurate indicator.
  • Investors are also interested in looking at the ROI or Return on Investment especially when acquiring a firm. It evaluates the efficiency of an investment and can be calculated as the benefit of an investment divided by the cost of the investment.
  • EVA or Economic Value Added is an expression for the economic profits of the firm or the profit earned less the cost of financing the firm’s capital. It indicates shareholder value. A related concept is Market Value Added (MVA) or the discounted sum of all future expected economic value added.

As seen above, discounting of cash-flows or future profit estimates is critical to finding the current value of any business. Many tools are available to arrive at this market. However, in all approaches, it is important to remember that the value of the firm is ultimately nothing except what the investor and the market places on it. Even if you have your calculations just right, they must be in sync with how the market views your business. This is where the importance of keeping an eye on market trends and where your business stands comes in. While traditional methods and calculations might look good on paper, they will not hold if not adjusted for market expectations. The value of your business must reflect the value you promise to deliver to your investors. Avoid the tendency to overvalue your business. Make use of realistic figures and justified estimates of future earnings. For a new company, the breakeven point is another critical calculation, important not just for investors but for you as an entrepreneur. Make sure you don’t overlook it!

Unnati NarangAbout me:Unnati is a freelance writer, author and entrepreneur. From her blog to media initiatives like Times Ascent, HT Edge and The Better India, she is always keen on any writing opportunity that may come her way. Her writing bug extends to her venture, a publishing portal she co-founded early 2009, for emerging authors. She is also the author of Drenched Soul (poetry) and If At All (Fiction).

0 thoughts on “Business Valuation made easy”

  1. I refer to part 3 with reference to your discussion of IRR.
    You say:
    “However, this method makes the assumption that all earnings are reinvested at the IRR itself, which may not always hold true.”

    This is a common error, IRR does NOT assume that earnings are reinvested at the rate of IRR.
    You can of course reinvest earnings at the best rate that you can find in the market but you are now measuring the return on the project which includes reinvested earnings.

    The False Reinvestment Assumption and the Propagation of Incorrect Ideas – Part 1 by Jonathan Langton

  2. I went through your link. Traditionally, the reinvestment approach has always accompanied the evaluation of IRR method, but I will have to agree that since use and application of free cashflows from an investment need not be contingent upon the rate of return on the investment itself, this assumption may suffer from slight logical fallacies.

    Thanks for pointing out and sharing your insights!

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