Valuation of a company or asset is a need that shareholders, business owners, managers and investors may encounter. During preparation of court opinions, valuations or consulting conversations with clients and potential clients, we often encounter situations where people do not really understand the importance of professional valuation and / or are not familiar with the various methods used for valuation and the relevant professional terms used in valuations.
Valuation is a complex matter. Value can be relevant in the process of merging or splitting a company, adding a partner, parting from a partner, deciding to buy or sell a business or asset, deciding to liquidate a business or sell it as an operating business, raising capital or debt and more.
In this article, we seek to provide an “under the hood” glimpse of valuations and provide background to the essential methods and terminology used in the valuation practice of companies and assets. What are the basics you need to know? When are the primary methods used? and more.
Valuation is an appraisal of the company / asset which is the target of the valuation. In professional practice, different assessment approaches have evolved. The three primary approaches are:
The Income Approach
The approach focuses on the asset’s ability to generate cash. According to this approach, the value of the asset is based on the current value of the cash flow expected to result from the asset over its economic life. Performing a valuation according to this approach includes identifying the expected cash flows from the asset during its lifetime after a tax deduction. and the discount of cash flow at the capitalization rate that considers the time value and the associated risk factors.
The Market Approach
Iin accordance with this approach, the fair value is best valued by the prices recently paid for similar assets. Adjustments to the quoted market prices are made in order to reflect the differences in condition and use period between the evaluated asset and the similar assets.
The Cost Approach
In accordance with this method, the fair value is evaluated using the replacement costs of the asset net of the depreciation, which expresses the functional, economic, or technological depreciation of the current asset in comparison to the new asset. The valuation results from the cost method can be considered as the upper boundary of the value in the cases where the asset can easily be replaced or renewed; since no careful investor will purchase an existing asset for more than the price it costs to produce a new equivalent asset.
The logic of the DCF-
As mentioned, the most common methodology, which is based on the revenue approach and used under a going concern assumption, is the DCF- Discounted Cash Flow method. Under this method, an estimation of the company’s future results is performed, including the required investments, and working capital needs. The future values are then “translated” to their value at the valuation date using a capitalization discount rate. The discount rate helps translate future results while pricing the various risks and the cost of funding sources. The basic assumption behind the method is that if we take the future cash flow streams and “translate” them into their combined value at the valuation date, we will get the current value of the cash flow for that date.
Net Asset Value (NAV)
Net Asset Value (NAV) is one of the most popular valuation methods which is used when the value of assets represents their future potential, or in cases of a company facing realization or liquidation, or when there is doubt about the company’s ability to continue operating as a going concern.
Net Assets Value represent the excess value of a firm’s assets over its liabilities. The method measures the revenue which can be generated by the sale of the assets and repayment or sale of the liabilities in the market. It should be emphasized that this method estimates the economic value of assets and liabilities, which may not necessarily correspond to their book values (for example, a structure or land of the company’s plant whose value at sale may differ from its historical book value).
Self-performed valuation
We are often asked questions like, “Why do I need a valuation?” and after the question comes a statement like: “I can do this on my own and use a PE or EBITDA** multiples”.
Multipliers are indicators only and do not necessarily represent the value of the valuation target. Here are few simple examples to illustrate the matter:
- Two companies with the same profit, but one of them has high debt. Are the two companies worth the same? After all, the company with the debt will have to pay it back and therefore it should be deducted from the shareholder value.
- Two companies with the same profit: one has 100 customers, none of whom is substantial, and the other has a main customer generating 70% of revenue. Clearly, the risk is not the same.
- Two companies with the same profit but one company has credit terms of 120 days for its customers and the other 30 days. Both companies have payment terms to suppliers of 30 days. Therefore, the working capital needs of the first company will be higher than those of the second and the cash flow they will generate will not be the same.
Moreover, when purchasing an intangible asset, splitting operations, allocating shares, etc., the tax authorities, minority shareholders and others may require a valuation. In these cases, usually after it becomes clear that the self-performed valuation is insufficient, the value of a valuation carried out in real time will usually exceed the value of one made retroactively,
Preliminary valuation
Sometimes at an early stage of a transaction to acquire an asset / company, shareholders, business owners, managers and investors are interested in obtaining an initial indication of value. In order to provide the indication, a preliminary indicative estimate can be carried out based on various data sources, such as: data on similar transactions, multipliers, etc., while making the necessary adjustments to that data to the valuation target. This practice may delay the performance of the valuation to more advanced stages of the transaction and save money in cases where a decision is made not to move forward with the transaction. It is important to emphasize that a preliminary valuation is only an indication and is not a replacement for a complete valuation.
How much is the company/asset worth?
The valuation is an outcome of various parameters as presented in the examples above and many other issues. The value of a company / asset is based on the company’s / asset data including income, expenses, profitability level, tax rates, working capital needs, investments, forward-looking assumptions, risk factors, comparable data including data of similar transactions (with relevant adjustments), market conditions and more. Using the data professionally helps to estimate the value of the company/asset.
It is important to note that valuation is not an exact science. The valuation method and assumptions used by the person conducting the valuation can have a material impact on the results of the valuation. Therefore, conducting or examining a valuation should be carried out by an experienced professional who fully understands the goals and the objectives of the valuation.
In this article we mentioned the main assessment methods. We did not address additional special methods, including models used for valuations under increased uncertainty conditions, valuation of risky assets, and more.
So, how do you what’s the worth of your business activity? How much money should you ask for from a new partner or what price should you offer your existing partner to buy him out? How much to offer for a business you want to buy? How do you value future potential? How do you value an option in a transaction? How do you overcome conditions of uncertainty?
Ben Shmuel’s Economic Department comprises of experts with vast experience in various types of valuations. We will be happy to assist.
(*) Prepared by Ygal Dikovsky CPA (M.B.A.)
(**) PE multiple is the ratio between the price and the earnings (net income), An EBITDA multiple is the ratio between the price and the profit before financing and depreciation expenses.
