How to How the valuation of a business is done

A realistic valuation of your business is necessary in any respect – whether you are planning to buy a new business or pondering over a possible merger or maybe you plan to invest in buying additional land, plant or machinery.

Instructions

Difficulty: Easy

1. What does a business valuation need?
   A realistic business valuation requires more than merely looking at last year's financial statement. A valuation requires a thorough analysis of the past several years the business has been running, how it has grown, levelled or dipped, and a realistic forecast about the future outlook of the particular industry the business is operating in, the economy in general and how the particular company plans to compete in the emerging scenario.
   There are many hard-to-measure intangibles that are necessary factors in deciding the value of a business. It is not simply a process of adding up the numbers from a variety of reports. Business valuation has been called an art, rather than a science. Estimates of a business' value by various experts can vary as much as 30 percent.
   However chances are that a valuation professional may use the techniques discussed below to develop a range of values.
2. Asset Based Valuation:
   Book value—It is the difference between total assets and total liabilities, better known as net worth. But it does not really indicate market value of the business.
   
   Net adjusted value—In this method, the firm’s assets and liabilities are calibrated to current market value, giving adjusted book value. Again, it doesn’t correspond to actual market value.
   
   Liquidation value—The estimation of the company assets’ worth, when sold at auction or a distressed sale.
   
   These methods are rarely used because they don’t factor in future potential earnings and more often than not produce minimum values.
3. Income Based Valuation:
   Capitalization of earnings— This method arrives at the assumed value of the business by dividing previous year(s) normalized net earnings by assumed capitalization rate. The perception of risk determines the cap rate used.
   
   Discounted future earnings—In this method, present value is calculated discounting several years’ (perhaps five) future net earnings estimates. The sum of the present values may equal the assumed value of the business.
   Again, the discount rate used reflects the perception of risk associated with the purchase.
   
   Generally size, risk, profitability, and liquidity affect capitalization and discount rates.