Business valuation is the process of putting a monetary value on a business and is used whenever ownership changes, to establish the size of a business, to value equity and debt, or to assist in divorce proceedings. The 3-way model of business valuation is an analytical technique which can provide an accurate assessment of a company's overall economic worth.
Definition of Business Valuation
The goal of business valuation is to determine the economic worth of a business, based on its profitability, assets, liabilities and intangible factors. Business valuation can be used to arrive at the selling price of a company, the value of a company's stock, or to assess the worth of the assets and debt when a business is getting sold or merges.
Overview of 3-Way Valuation Model
The 3-way model is a comprehensive, detailed method of valuing a business which takes into account multiple key valuation metrics. This method uses three distinct models to place a value on a company: the asset, income and market approach. It considers all aspects of the business - from tangible physical assets to the intangible value of its brand – to create a more complete and accurate assessment of its overall worth.
- Business valuation is used to assess the financial worth of a company
- The 3-way model takes into account multiple key valuation metrics
- It captures both tangible physical assets and intangible value of brand
- It provides a more complete and accurate assessment of worth
Market Comparable Valuation
Market Comparable Valuation is a financial technique used to determine a fair market value of a business. Although the concept behind Market Comparable Valuation is complex, it is necessary for accurate business transactions and transactions such as mergers and acquisitions. This type of valuation estimates the current market value of a business by conducting benchmarking against similar businesses.
Definition of Market Comparable Valuation
Market Comparable Valuation is an approach used by financial professionals to estimate the value of a business by obtaining public marketplace data from similar companies within the same industry. The data is then used to analyze the market value of a business relative to other companies, allowing a professional to do a proper and accurate valuation. This valuation is then used to assess overall financial performance and the possibility of improvements.
The Advantages and Disadvantages of this type of Valuation
The primary advantage of this type of valuation is that it offers an objective way to analyze a business's potential for success. It also helps assess the accuracy of management's forecasts, which can be difficult to determine without an expert market analysis. Additionally, since the data used for market comparable valuations is obtained from public sources, it is more reliable than traditional financial statement analysis.
However, the process of market comparable valuation is often time-consuming and can be difficult to understand. Additionally, the process may require additional data beyond the initial benchmarking. Moreover, the data used for comparison must be carefully selected, as some of it may not represent the true market value accurately.
3. Earnings Capitalization Valuation
Earnings capitalization, or cash flow capitalization, is one of the three primary methods of business valuation, along with asset and market approaches. This useful method of valuation is used to determine the present value of future cash flows by first forecasting the earnings of a company as part of an income-based valuation.
a. Definition of Earnings Capitalization Valuation
Earnings capitalization is based on the idea that the value of a business is the present value of its future earnings. The two primary components of this method of valuation are determining the future cash flows and the rate of return that is used to discount those future cash flows to the present.
b. Calculating the Cash Flow from a Business
In order to calculate the cash flow of a business, start by determining the expected or forecasted earnings. This includes taxes and operating costs like salaries, supplies and rent. This figure can be determined from the company’s historical earnings, or estimated future earnings. This is the "discounted" earnings.
c. Understanding the Multiple Used in this Method
Once the expected or discounted earnings of a business have been determined, multiply this figure by a company specific multiple to arrive at the estimated market value of the business. The multiple is typically based on the size of the business, level of risk associated with the business, and the market conditions.
Discounted Cash Flow Valuation
Discounted Cash Flow Valuation (DCF Valuation) is a powerful tool which is used to provide an estimate of a company's current worth. It is based on the premise that cash flow generated from its operations determines a company’s value. By taking into account the future cash flows and discounting them to their present value, investors can assess the value of a company's stock or business.
Defining Discounted Cash Flow Valuation
Discounted Cash Flow Valuation (DCF Valuation) estimates a company’s value by predicting its future cash flow and discounting them to their present value. This valuation method is based on the idea that the value of money today is more than its value in the future. To arrive at a company’s fair value, first, investors need to estimate the future free cash flows for the company and then discount them to their present value. The free cash flows are the cash left after deducting all expenses, debt, and taxes.
Calculating Present Value of an Investment
To calculate the present value of an investment, the future cash flows are discounted at a rate called the discount rate. Discount rate reflects the expected rate of return on a project or investment and is calculated by taking into account the time value of money and the investment’s inherent risk. The discount rate is also calculated using other factors, such as the cost of capital, cost of debt, and the inflation rate.
Determining Discount Rates
To determine the discount rate for a project or investment, the following variables are considered:
- Cost of equity: The rate of return that investors expect from the company when they invest in it.
- Cost of debt: The rate of return that a company needs to pay for its debt.
- Inflation rate: The rate at which the prices of goods and services increase over time.
These variables can help investors determine the discount rate and calculate the present value of the company’s future cash flows. By adding the present value of all future cash flows, investors can estimate the value of the company today.
Pros and Cons of 3-Way Valuation Model
The 3-way model, also known as the discounted cash flow model, is a popular and reliable model used to value a business. While this model has a number of pros, it can also lead to impractical solutions and costly mistakes. It’s important to weigh the pros and cons of the 3-way model prior to making a business valuation. The following provides an overview of some of the pros and cons associated with this model:
- Facilitates Comparisons Between Businesses: The 3-way model provides an objective way for owners, investors, and other stakeholders to compare different businesses and determine which is the most attractive investment. The model also helps to identify potential future risks and rewards for each investment.
- Can Lead to an Impractical Solution: The 3-way model is based on a variety of assumptions and estimates which can often lead to a solution that is not strictly realistic. If the assumptions and estimates used in the model do not reflect the true value of the business, the 3-way model will produce an inaccurate valuation. For this reason, it is important to take any 3-way model valuations with a grain of salt.
Guiding Principles of 3-Way Valuation Process
A 3-way model for business valuation is a complex and intricate process that requires technical knowledge and an understanding of business trends, practices, and strategies. To ensure a successful outcome for any 3-way model for business valuation, there are certain guiding principles and considerations that should be taken into account.
Determining the Viability of Potential Investments
Before a 3-way valuation is conducted, it is important to determine the viability of potential investments. Factors such as the company’s liquidity, profitability, product or service offering, and overall market demand, should all be taken into consideration when assessing the potential for a given investment. Additionally, the underlying legal and regulatory environment, macro-economic factors, and industry trends should be explored and accounted for in order to provide a comprehensive look at the investment’s potential.
Using Projections for Future Years
When establishing a 3-way model for business valuation, it is important to project the revenues, expenses, and cash-flows for future years. This will provide a clear picture of the company’s ability to generate growth and profits over the long-term, and will allow for accurate forecasting of potential returns on the investment. Additionally, any tax or regulatory implications should be taken into consideration when developing forecasts.
Understanding Limitations of the Model
Businesses are constantly changing and evolving, so 3-way models for business valuation must be regularly updated to account for fluctuations in the economy, industry, or business landscape. Additionally, any assumptions or forecasts must be tested and reassessed over time to ensure the results remain valid. Finally, the limitations of the model should be evaluated, so that the highest accuracy and most reliable results are achieved.
- Determine the viability of potential investments
- Use projections for future years
- Understand the limitations of the model
At the beginning of this blog post, we discussed the importance of business valuation, the three primary methodologies used, and the advantages of a three-way approach when valuing a business.
The three primary methods used in business valuation are asset-based, market-based, and income-based. Each has its advantages and disadvantages and several nuances unique to each method. Asset-based valuation examines the tangible assets of a company and is good for determining the liquidation value of the company. Market-based valuation looks at what similar companies in the same industry are transacting for and is good for low-transparency industries. Income-based valuation looks at the current and future cash flows of the company and takes into account all forms of capital and income.
A three-way valuation model combines these three methods and provides a well-rounded picture of the business and its potential. This model looks at the current situation, considers the future of the business, and is useful in any industry.
Recap of the 3 Types of Business Valuation Method
The asset-based valuation method looks at the tangible assets of a business, the market-based method looks at similar companies in the same industry, and the income-based method looks at the current and future cash flows of the company.
Overview of the Pros and Cons of the 3-Way Valuation Model
The three-way model combines the good aspects of the other three models, giving a well-rounded view of the business, but this does come with its drawbacks. The primary benefit of this model is that it includes all three methods, giving buyers and sellers a comprehensive assessment of the business. However, the drawbacks are that it can be more time- consuming, it can be more expensive, and it can be more subjective.
Summary of the Guiding Principles when Executing this Model
- Ensure all three aspects of the model are in-sync with each other;
- Ensure that all of the assumptions are documented and verifiable;
- Document all of the relevant financial and non-financial data;
- Ensure that a proper-level of analysis is conducted; and
- Be honest and conservative when making assumptions.
To summarize, using a three-way valuation model gives buyers and sellers the best idea of the value of the business without having to go through lengthy process — including the full range of regulatory and legal requirements — for a more traditional sale process. While the three-way model takes more time and can be more expensive than the other models, it does provide a comprehensive view of the business and its potential. When executing this model, it is important to keep in mind the guiding principles outlined above.