This is the second part of a two part article on the topic.
Making Sense of Valuation
By Federica Nazzani
Approaches to value
There are three general approaches to valuing a business and/or asset, namely the cost, earnings, and market approach. The approach adopted will be determined having regard to factors specific to the company including profitability and the risks related to the operations of the company as well as industry and economic conditions.
Cost approach
The cost approach is (i) the sum of the costs required to replicate the asset or (ii) the book value of the assets and liabilities of the business. The cost approach may be appropriate where the value of the business interest does not include intangible value and the earnings potential of the asset does not exceed its cost. This approach does not consider competitive strengths and weaknesses, potential for earnings growth or risk associated with achieving the earnings of the business and therefore, requires significantly less judgment than alternative approaches. This approach most often results in relatively lower valuation.
Earnings approach
The basis of the earnings and/or cash flow approach is the future economic benefits derived from the business and/or commercial exploitation of the asset, taking into account the risks associated with achieving those benefits. Most important to a purchaser of a business and/or asset is the ability to generate future earnings and cash flows and satisfy an investor’s expected return on investment. It is determined by applying an appropriate capitalization/discount rate to a selected stream of historic and/or prospective earnings or cash flows. The more aggressive the cash flows or earnings assumptions, the higher the capitalization/discount rate for achieving those projections.
A variation of the earnings approach, most often adopted in corporate finance, is the discounted cash flow technique (“DCF”). DCF is calculated as the present value of future cash flow expectations. It is applied in various situations where a business is in start-up or growth phase or forecast to experience a change in operations (i.e. merger, divestiture, etc.), or in instances where the business has a finite life. The preparation of a detailed financial forecast will require a detailed review of the historic performance, internal operations and relationships between revenues and costs, and an analysis of the external competitive environment (i.e. trends of competitors and industry as a whole).
Market approach
Value determined based on the market approach is often based on the use and analysis of comparable transactions in the marketplace. These transactions are a good indication of the prices paid in the marketplace for similar assets and/or business interests. However, certain transactions do not provide a direct means of determining value as it is often difficult to find comparable assets and/or business interests and public disclosure of transaction information is frequently not available.
Understand the basics
The valuation exercise is best described as “an art, not a science”. This is correlated to the level of judgment that is required in supporting value. Arriving at a valuation or the worth of a business and/or asset will require an understanding of the basics including a defined and supportable business model, thorough assessment of the future operations and relative risks, and a clear understanding of the competition and industry trends.
Please contact Federica for more information on this important topic. She can be reached as follows:
Federica Nazzani
President
Capital Assist (Valuation) Inc.
Tel: 226.347.8100
Email: fnazzani@capitalassist.ca
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