Your company's true worth: How to value your business

Learn about the proven and widely accepted business valuation methods that help provide a good starting point for estimating value.

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The Net Asset Value (NAV) is the easiest to understand. It is calculated simply as fair value of the assets of the business less the external liabilities owed.
The need for a business valuation can arise for several reasons: incoming investors, lawsuits, inheritance, business sale, partner exit, public offering, or networth certification. So, how would you go about estimating this value? Yes, it is a complex subject that has confounded the best investors and academicians. Yet, there is a certain common sense about business valuation that everyone can grasp and which provides a reasonably close (and sensible!) estimate.

The 3 primary valuation approaches

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Market-based approach
Under this approach you:
1. identify a comparable firm (same industry, similar business and markets)
2. identify the suitable multiple to be used (detailed below)
3. choose the correct variable and multiply

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Some of the most popular multiples are:
a. Price/Earnings (P/E): Under this method, the Profit After Tax is multiplied to arrive at an estimate of equity value. While it is the most easily understood and widely used, the main issue is using Profit After Tax, which is affected by a number of accounting adjustments and distorted by capital structure. Besides, a consistent track record of profits is needed for P/E to make sense.
b. Price/Sales (P/S): Compared to P/E, P/S is less distorted, easier to calculate, and not affected by capital structure. Moreover, it is useful for firms that do not have consistent profits, and more appropriate for certain sectors like retail.
c. Price/Book Value (P/BV): This method uses a multiple applied to the book or accounting value of net assets of the company. P/BV is particularly relevant for sectors where income (and thus, value) is entirely dependent on the value of assets, such as banking.
d. EV/EBITDA: EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortisation is widely regarded by analysts as more reliable since it removes distortions like effect of capital structure, varying tax rates, and non-operating income. Since EBITDA is the earnings before interest, the appropriate value in the numerator is taken as the Enterprise Value, or value of debt plus value of equity, plus cash balance.

Asset based approach
The Net Asset Value (NAV) is the easiest to understand. It is calculated simply as fair value of the assets of the business less the external liabilities owed. The key here is determining fair value, especially of assets since fair value may differ significantly from acquisition value (for non-depreciating assets) and recorded value (for depreciating assets).
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Also, the true value of your company may be significantly higher than the simple addition of the net assets. Things which you never paid for may form part of the value, as would a unique way of doing business that gives your company an advantage. An extension of NAV - the Replacement Cost Method - takes care of some of these issues. Put simply, it is the value any objective person would pay to set up a business that is exactly the same.

Income based approach
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This primarily involves calculating the value of the company using Discounted Cash Flow (DCF). In short and very simply, this means calculating the present value of the future cash flows of the company. The discounting to present value is done using the cost of capital of the company. Depending on the objective, cash flows to the firm (that is, before debt obligations) or cash flows to shareholders may be used. The former will result in an Enterprise Value (value of debt + value of equity) and the latter Equity Value. DCF being a complex subject will be dealt with in a separate article.

With so many choices; how do you pick a method? Again, the answer isn't complex, but involves common sense:
a. What data is available
b. Appropriateness of the method to the situation, industry, and the business
c. Level of detail desired

Often times, value estimates under multiple methods are prepared and the final valuation is taken as the average of each.

The only rule to remember is that invariably, intuition, common sense, and acceptability will trump complexity, high math, and copious data.

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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