Is valuation an art or science? Business valuation and business valuation methods is one of those fuzzy subjects that can be easily misinterpreted. The task of valuing a business or company is more of an art rather than a science as valuation requires significant judgement from the valuator. There are various approaches to determining a company’s value. Two valuators may pick a different valuation method for the same company, and even with the same method, the final valuation figure may differ because of the inputs.
One key question the valuator will face is to determine which valuation methodology is most appropriate for the company. The valuator will need to consider the purpose of the valuation and the nature of the business operations to identify the valuation approach and appropriate business valuation methods to adopt.
Purpose of Valuation
While accounting standards for valuing a firm or public shares may assist as models, many will agree that it is important factor is the purpose of the business valuation. Common reasons for valuing a business include the following:
- Buying a business, merging a business, acquiring a business or a business line;
- Selling a business, divesting a business line or business interest, forming a joint venture;
- Structuring a buy / sell agreement for a partnership or a minority shareholder;
- Dissolution of a partnership or corporation;
- Bankruptcy / reorganisation;
- tax planning / estate planning;
- Shareholder disputes for estate or divorce.
It is also imperative to consider the type of business when selecting a valuation approach. Companies with significant assets in properties, machinery, or inventory would want to factor the appraised market value of these assets as part of the total business value as oppose to service companies with fewer assets.
Professional practices such as legal firms, health care, consulting, investment advisory, and businesses operating in industries such as real estate and insurance may also have specific goodwill characteristics that need to be considered when valued.
Even valuators using the same valuation methodology may arrive at differing values to the firm. While there are certain mathematical formulas for valuation that we use to value a company, the inputs require a certain level of judgement from the valuator.
Valuation using the income approach requires a forecast of the company future cash flows and an appropriate discount rate. The cash flows are determined by future events such as market trends, economic outlook, post- acquisition synergies and effects of management changes. The valuator must quantify these and make a call on the inputs of the forecasted cash flows. This can prove to be a rather complicated exercise, especially when it comes to start-ups.
Historical Financial Information
While valuations typically use historical financial information as a base for its projections, start-ups do not have many years of financial data that the valuator can rely on to validate the growth assumptions that the owners provide. A tech start-up may also be building its consumer base and have not started generating a positive cash flow. The valuator needs to have a good understanding of the business to determine if the assumptions are not overtly optimistic or pessimistic.
Using market comparables also requires judgement as no two companies are the same. Businesses in the same industry sector have varying customer concentrations, operate in different regions and have different cost structures. When it comes to small private companies, it may also be difficult to find a comparable market player or information to historical transactions. The valuator needs to have industry experience or ask the right questions to make an informed decision on the inputs to the valuation.
All in all, the valuator needs to have a good understanding of the purpose of the valuation and the unique characteristics that firm / business has and its external environment to arrive at a meaningful valuation.