Valuation methods and tools
In executing a valuation, various methods can be used. The following section functions as an introduction to the following valuation methods:
- Market Based Approach
- Multiple approach
- Income Based Approach
- Asset Based Approach
- Rules of Thumb
- German income approach
- Liquidation value
It furthermore acts as an overview of the various valuation tools available in different countries.Market Based Approach
The Market Based Approach is a valuation technique in which the market value of the shares is estimated by comparing the subject company to companies which have been sold (recent genuine offers) or whose ownership interests are publicly traded (when there is a liquid and active market.
Challenges creates the missing availability of data in general and from comparable firms in particular; could be used as a second method to validate the first one.
Multiple Approach
Through this approach, the value of the a firm in a future year is estimated by applying a multiple to the firm's earnings or revenues in that year. If valuing equity, equity variables such as price-earnings ratios are used.
While this approach has the virtue of simplicity, the multiple has a huge effect on the final value and where it is obtained can be critical.
Multiples facilitate the identification of a price not of a value; for the majority of SME transactions no data is available; EBIT and EBITDA multiples are dependent on the accounting standards. A number of comparable companies are needed to execute the method (comparable in the sense of risk, profitability, growth). These companies should be found in the same sector/industry the company to be valued is operating in. To further increase the quality of the comparable companies geographical coverage, comparable business model, profitability, growth and capitalisation ratio should be considered. One should be aware of potential outliers.
The method is strictly market driven. This however also means that the method is exposed to all inefficiencies of the market.
Income Based Approach
Determines the value of the shares based on the expected returns from the subject company and the required rate of return thereon.
Discounted cash flows: Considered as the most appropriate method in the calculation of the value where there is adequate information about likely future cash flows, usually over a finite term.
This method is less appropriate when:- History not indicative for the future
- Subject company is not large enough
- The company is not sufficiently profitable
- A start up company is valued.
Asset Based Approach
Determines the value of the shares having regard to the market value of the assets and liabilities thereof. It is relatively easy to calculate (apart from hidden reserves).
Rules of Thumb
Expresses the relationship between the price and certain variables based on experience, observation, hearsay, or a combination of these; generally industry specific.
The problem with rules of thumb is that they are based on average multiples derived from transactions involving companies that may or may not be comparable to the subject. And, they are often based on subjective judgment or word of mouth rather than objective sources of verifiable data.
It is also easy to calculate.
German income approach (Ertragswertverfahren)
The income value is calculated on the basis of, first, the periodically attainable net income derived from reliable data within the given period and, second, the residual value of the company at the end of this period.
The basis for a decent calculation forms a business plan. Thereby, two to three scenarios should be calculated. The assessment and weighting of possible risks is not the sole responsibility of the evaluator, but in particular that of the buyer/successor.
Liquidation value
There are two ways to estimate the liquidation value:- based on the book value of the assets adjusted for any inflation during the period. Limitation is that it is based on accounting book value and does not reflect the earning power of the assets.
- To estimate the value based on the earning power of the assets (we would have to estimate the expected cash flows from these assets and then discount these case flows back to the present, using an appropriate discount rate). Finally, when valuing equity, the estimated value of debt outstanding in the terminal year has to be subtracted from the liquidation value to arrive at the liquidation proceeds for equity investors.
Valuation tools in different countries
The following drop-downs give an overview of valuation tools available in different countries.
- Valuation methods and tools