“Valuing Businesses is part art and part science”
Growth, diversification, and sustainability! There can be many other reasons why a company acquires or merge with others. However, not all mergers and acquisitions result in a success story, many fail. There are many examples, like Google’s acquisition of Motorola for USD 12.5 billion in 2012 ended up Google divesting Motorola for USD 2.9 billion. Similarly, Microsoft’s acquisition of Nokia for USD 7 billion in 2013 resulted in Microsoft writing off the investment and laying off 15,000 Nokia employees in 2015. There are many reasons for a miserable acquisition; however, the most common is an inaccurate valuation of the business acquired.
How to determine the Company’s worth
There can be various ways in which a company or a business can be valued. Some of the most commonly used business valuation techniques are as follows:
- Asset-based methods.
- Earnings-based methods.
- Cashflow-based methods.
The selection of the valuation method depends on the business structure and the purpose of the valuation.
It is the simplest way of estimating the business valuation of the Company. Under this approach, the business is valued based on the net assets of the Company. However, the net assets themselves can be valued using any of the three methods:
- Book value – The book value or the carrying value appears in the Company’s financial statements. The problem is that book value is useless and is not reflective of the Company’s actual value.
- Net realizable value – This is the value a business or Company would fetch if it wants to close its business now. It ignores the basic concept of going concern with the business; hence is not reflective of the running business value.
- Replacement value – This is the amount required to set up a similar business now. This method also ignores the brand value or goodwill of the Company instead provides a value of a new business setup.
Earnings Based Methods
Earning based approach to valuation uses the earnings or profits of the Company to drive the business valuation. The following two standard methods are used under-earning based valuation approach:
Discounted earning method – It ignores the business’s future earnings to arrive at the business’s current value. This method assumes that the Company’s value is derived from its earnings, which is a valid assumption but has some drawbacks. The Company’s profits may include certain accounting adjustments that may not reflect the valuation and should be excluded when using this method. Further, earning does not necessarily mean the cash flow or dividend from the business. Therefore the timing of the earnings may not be an accurate depiction of the cash flows derived from the Company.
P/E method – P/E or price earning method is an uncomplicated elementary method of business valuation. Under this approach, you can calculate the P/E ratio of a similar company traded in the stock exchange and apply the same proportion to your Company’s earnings.
Cashflow Based Methods
Under the cash flow method, the Company’s valuation is determined by discounting the business’s future cash flows. This method is mainly used in the most complex and large business valuations. However, predicting the future cash flow of a business is a difficult task and often requires several assumptions. The cash flow method uses sensitivity analysis to cater to a change in future cash flows’ variation. E.g., the recoveries from customers are taken as 30 days, 45 days, and 60 days to see how the recoveries from the customer are impacting the business valuation.
The valuation of a business is more of an art than a science, and often the methods or approaches discussed above are not the only solutions. Combining the above techniques is often used with many other qualitative factors, such as business synergy, culture, etc. These decisions are based on an all-inclusive view rather than a simple calculation.