INTRODUCTION TO VALUATION
In an efficient capital market, the best estimate the value of the firm is given by the current share price multiplied by the number of shares in issue. There is only one element of value which is missing from this calculation and that is the difference between the firm as it is currently operated, and the value of the firm as it could be operated adopting the best management practices available, minimising the firm’s cost structure, and maximising its available product opportunities. This difference in value between how the firm is currently, and what it potentially could be, we term the control premium.
There are four main approaches to valuing a firm
- Asset valuation: where a summary of the assets less the liabilities of the firm are valued on some agreed basis.
- Relative valuation: this involves valuing some measurable attribute of the firm, such as its current level of earnings, dividends, or book value, in terms of the price that the market is prepared to pay per pound or dollar of these attributes.
- Flow valuation: this entails identifying a value flow (usually earnings, dividends or cash flow) and converting them to a present value.
- Contingent valuation: where the firm is valued in terms of the present value of the expected cash flows plus some premium for any future growth options.
The traditional approach to valuation of a firm is to add together the value of all the firm’s tradable assets less any outstanding liabilities. For an ongoing business the appropriate basis for the valuation of its assets is their replacement cost. Providing all of the firm’s assets are captured within the valuation process, then presumably if the investors were by some mischance deprived of the firm then they could reinstate it in its original condition by repurchasing all of the assets involved.
There are some obvious problems with this in that many assets are not tradable and, indeed, are accumulated over long periods of time. Some assets may be of an intangible nature and are not directly replaceable in the market. More problematically, assets exhibit differing degrees of “entanglement” with one another. So the idea that the value of a firm is equal to its replacement cost is only true at the level of the business as a whole and is not the same as saying that it is equal to the sum of the replacement costs of its parts.
However, this approach has been widely used particularly for the valuation of small businesses.
In order to cater for the inherent goodwill of a business to this value is added either a multiple of annual turnover or a multiple of annual profits, depending on the nature of business or industry convention. The various industry rules of thumb, used by small business brokers are given below (note – asset value are added to these amounts):
Valuing a small business (The Business Reference Guide, 2003)
It can be seen this method of valuation of a business is more suitable for a small local business operating in a stable environment, where the goodwill which Is intangible can be transferred to the new owner, which is however not guaranteed, Hence is gives a starting figure to negotiate, and the final price is dependent on the negotiating powers of the parties.