Valuation is a much-talked-about topic in corporate accounting. One of the basic duties of a financial controller is measuring the economic value of a business, its assets, and its divisions.
Knowing the fair value is crucial if and when a company wants to sell or purchase assets, establish a partnership or seek funding. It is also necessary for business acquisition or sale and taxation.
This article is a concise guide for controllers and accounting executives to understand valuations.
What is Business Valuation?
Business valuation is the process through which the current intrinsic or true worth of a business is determined. Business valuation analysis can help businesses avoid being undervalued or overvalued during a merger or acquisition.
In valuing a business, controllers may analyze capital structure, company management, the market value of its assets, or future earnings.
Several financial tools are used to compare the values of companies, especially during M&A. Some of the most common tools used are known as multiples.
Multiples are used to evaluate one metric in ratio to another. For example, a company’s earnings in a fiscal year are in ratio to its share price (earnings per share). They are mostly used as transaction comparables.
To get a detailed analysis of a company’s valuation, however, several records need to be reviewed. These records help estimate the future income potentials of a company by carefully analyzing its financial health in the past.
Some of these records include financial statements dating back 5 or 10 years, corporate records, debt records, employee records, and others. Typically, these records are a crucial part of the due diligence report.
Methods of Valuation
There are more than a few methods or models for valuing businesses. These methods are generally grouped into two categories:
- Absolute valuation models focus on the fundamentals of the business. These models assess parameters like cash flow, dividend yields, growth rates, and more.
- Relative valuation models use multiples to compare similar companies and assess the potential of a company against its peers. These models pay little to no attention to the internal financial health of a company.
Below is a highlight of some of the most popular valuation methods (absolute and relative).
Comparable Company Analysis
Comparable company analysis (“comps” for short) is a relative valuation methodology that uses ratios (or multiples) of similar companies to estimate the value of a particular business. This method of valuation analysis considers several factors when picking the businesses to compare. Some of the factors include:
- Industry classification,
- Size of the workforce,
- Asset value,
- Growth rate and
Financial information needed to generate useful multiples may include gross profit, earnings before interest, taxes, depreciation, amortization (EBITDA), and earnings per share (EPS). For publicly traded companies, these details are available in their annual financial reports accessible on the SEC website.
Discounted Cash Flow (DCF) Model
DCF is an absolute valuation model that estimates the current value of a company based on the future income forecast. Estimating the future finance of a company may be a tad difficult. For early-stage startups, it’s almost impossible to do that. However, controllers can use the DCF method to value a business by calculating its net present value (NPV) and forecasting the net cash flow for a particular duration in the future.
DCF valuation is critical to decisions such as a huge stock purchase or corporate acquisition. Also, controllers and managers can apply the DCF method to decide the operational costs and capital budget of their departments and the entire company.
Precedent Transaction Analysis
Precedent transaction analysis (or simply precedents) is a valuation method that uses past M&A transactions of similar firms to estimate the value of a company. It considers the prices paid for similar companies as an indicator of the company’s value. This type of valuation is commonly used when a company is preparing for a merger or acquisition.
Like comps, the precedent transaction relies on publicly available information to create multiples. Research reports, annual filings, trade publications, and the Securities Data Corporation are excellent sources of such information.
The market capitalization method is considered the simplest form of business valuation. So, it is popularly used and commonly trusted as a near-accurate estimate of a company’s valuation.
The market cap of a listed company is estimated by multiplying the unit share price by the total number of sold shares. As an example, the market cap of a company with 5 million shares selling for $50 each would be $250 million.
This business valuation method is used to determine the maximum value of a business. It is commonly used by controllers when making an offer for the acquisition of a company. It provides a framework for negotiation.
To use this times-revenue method, evaluators usually multiply the sales cash flow of a company by certain values which are determined by the company’s industry and economic environment. The generated values serve as a range of the company’s valuation, informing potential buyers to start negotiation from the lower end of the range.
Other than these highlighted models of business valuation, there are several other methods for estimating the value of a company that controllers may need to understand. These other evaluation methods may include the earnings multiplier, liquidation value, breakup value, book value, and asset replacement value.
What method should you use?
With so many valuation methods, choosing one to work with can be a tad difficult. In reality, however, each method is best fitted for different situations.
The industry and unique characteristics of the business can indicate whether a straightforward and absolute method will suffice or there’s a need to combine several methods (a complex valuation solution).
Applying different methods of valuation to the same business may give varying values. Most times, analysts and controllers choose the method that will give them the most favorable result based on current best industry practices. To a large extent, also, personal preference can influence the controller’s choice of methods as much as the business model.
What is a controller if he/she has no way to estimate the value of a company?
Valuation analysis is one of the primary duties of controllers and there are diverse ways to go about it. Understanding the various methods of estimating the valuation of companies and choosing the right method is what sets outstanding controllers apart.
Therefore, forward-looking controllers, looking to strengthen their careers should consider honing their skills in business valuation analysis.
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