Commerce is one of the most ancient business activities of humanity, with price always playing a central role. The establishment of companies created a market for them too, together with the need for determining the value of companies. In our previous series of articles on the quick evaluation of investments influencing the business decisions of companies, we analysed methods such as cost comparison, profit comparison, calculating profitability and calculating depreciation. In the series starting with this article we will elaborate on different methods for business valuations, highlighting where they can be used.
Price or value?
The price and value of something may not necessarily be the same, the two notions differ in their content. Value is an amount that can be calculated precisely according to one or more methods, while price is formulated much more through negotiation. Value can constitute a basis for price negotiations, whereas price may be influenced by countless other factors too. Is there any demand, namely a market for the given product / company? Can further synergies be expected from the acquisition? What resources does the buyer have?
The value of a company is most often required during the business acquisitions, but a number of other events can necessitate business valuations.
When might business valuations be required?
The need to determine a company’s value can arise in the following situations:
- During the sale and purchase of a company’s ownership share, negotiations usually start from an objective value.
- If a member or shareholder leaves a company, the settlement with them generally involves determining a market price for the company.
- Analysts prepare business valuations to support investment decisions and in relation to the sale and purchase of shares on the stock exchange.
- A well-founded enterprise value can be crucial in determining an independent market price for tax purposes during the sale/purchase of a business division or an entire company within a group.
- When buying a company, IFRS dictates that the purchase price must be broken down into its constituent parts. Here, the valuation is carried out under the IFRS 3 Purchase Price Allocation method.
- Assessing a company’s value can be vital for start-up enterprises when bringing in external capital, which focus more on evaluating a given idea in terms of its feasibility and future success than on the analysis of the company’s past or present performance.
- The need for a valuation can also arise when selling an independent business division.
- In the event of closing down a business it is also worth knowing the value that can be expected following the wind-up of activities.
What methods can be used for business valuations?
Choosing the appropriate valuation method depends on the purpose of the valuation, its circumstances as well as the resources and information available.
The methods used most often for business valuations can be categorised as follows:
- methods based on company’s income-generating capability
- methods based on asset values
- comparability methods
One of the most commonly used methods based on a company’s income-generating capabilities is the discounted cash flow method (DCF) which is based on future business plans and cash-flow plans, and determines the present value of future cash flows with due consideration of market risks.
The methods drawing on asset values generally focus on book values and base their calculations on the difference between the value of assets and liabilities, i.e. the company’s equity. The objective is to determine the value of equity adjusted to market value by identifying hidden reserves in assets as well as any off-balance sheet assets and liabilities.
The comparables approach is based on market data. This procedure can be carried out by querying and evaluating comparative figures from different databases.
In the forthcoming articles of this series we will present the methods used most often. We will analyse which method is appropriate for which circumstance, and outline the strengths and weaknesses of each method.
If you have questions about business valuations, please contact our financial consulting experts!