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Written Assignment - Unit 5

BUS 5111-01 Financial Management

METHODS FOR BUSINESS VALUATION

Instructor: Dr. Sidney Okolo

University of the People

September 28, 2022

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Methods for Business Valuation

Introduction to the Business Valuation

Business valuation aims to measure the economic value the enterprise

creates and sustains both in the time spectrum of past, present and future.

Practical uses of the business valuation can be for “mergers, acquisitions,

reorganizations, spin-offs, liquidations, and bankruptcy; allocation of purchase

price (tax and financial reporting); estate, gift, and income taxes; marital

dissolution; buy-sell agreements; stockholder disputes; financing; ad valorem

taxes; incentive stock option considerations; initial public offerings; damages

litigation; insurance claims; charitable contributions; eminent domain actions;

fairness opinions” (Trugman, 2012, p.3). The benefit of valuing business is that

it allows shareholders, top-management and external entities to have a clear

picture of the realistic position of the company in the value ecosystem.

Major Methods of Business Valuation

Variety of approaches for valuing business are usually categorized into

main three approaches, that are, asset/cost-based approach; revenue/income-

based approach; and market-based approach (Fazzini, 2018).

Book Value and the Asset/Cost-based Approach

The book value means aggregate value of the asset’s original purchase

price, subsequent expenditures thereto, depreciation accumulated and

impairment charges (Accounting Tools, 2021) and it represents the historic

value of the asset. While book value is clearly stated in the financial statements,
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it can be adjusted or marked to market periodically (Accounting Tools, 2021) so

as to match the prevailing market prices.

1. It provides clarity and accurate data for managers and investors in

terms of how much financial resources were actually allocated to

acquire the asset;

2. it is criticized for being “overrated, since there is no direct

relationship between the market value of an asset and its book

value; and considered as a weak replacement for market value, if

no other valuation information is available about an asset”

(Accounting Tools, 2021, p.1) and not considering the earnings

potential that an asset may hold regardless of its historic costs.

Market Value, Market Capitalization and Market-based Approach

Market value is the company’s value in the stock market and indicates the

liquidity of the stocks (Seth, 2021). This approach employs sub-methods such as

liquidation value, salvage value, and comparable transaction method. Market

value formula, also known as market capitalization, “is calculated by multiplying

a company’s outstanding shares by its current market price, that is:

Market Cap = Price Per Share × Shares Outstanding” (Seth, 2021, p.1)

1. It is praised among the appraisers for the reason that “the market

approach is probably the most fundamental approach in a fair

market value appraisal. Because fair market value is supposed to

come from the market, it seems natural that this approach should

be greatly emphasized” (Trugman, 2012, p.285);

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2. However, finding a similar/comparable company and/or transaction

is a challenging task as the factors that determine similarity greatly

varies from company to company. Such factors include past growth

of sales and earnings, rate of return on invested capital, stability of

past earnings, dividend rate and record, quality of management,

nature and prospect of the industry” (Trugman, 2012, p.287) and so

on.

Future Value and Revenue/Income-based Approach

In contrast with the present value, future value expresses the prospective

value of a business at an foreseeable future date based on the assumed rate of

growth (Chan, 2021). This value approach has high practical importance for “the

amount of growth generated by holding a given amount in cash will likely be

different than if that same amount were invested in stocks; therefore, the future

value equation is used to compare multiple options” (Chan, 2021, p.4). This

approach bases its projections on future expectations and employs discounted

cash flow and

1. It relies on “the cash flows the firm will be able to generate in the

future” (Fazzini, 2018, p. 77) in order to compute the value of the

business. Such expected cash flows projection is critical to the

application of this method and exists in the centre of this approach.

2. Even though “the ability to generate cash from past operations is

often an important indication of whether the enterprise will be able

to pay for recurring operating costs” (Dauderis, Annand, & Jensen,

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2021, p.404), the future projections are always limited to

uncertainties.

Exhibit. Summary of Applicability of Business Valuation Approaches

(Mellen & Evans, 2018, p.219)

Other additional methods: Cost of Capital Approach and Liquidity

Approach

Cost of Capital approach estimates the value of an enterprise based on

the free cash flow from operations. “In this approach the costs and benefits of

debt are considered directly in the cost of capital used as a discounted rate of

the future expected free cash flow from operations” (Luca, 2018, p.368). This

approach is also helpful to calculate the tax benefits of debt financing used for

capital.
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Liquidity approach is another approach that determines the value of an

enterprise by the lower end of valuation range and it is usually considered as

alternative and static method. It is also criticized for being negligent on business

growth potential and leads to volatile prices for the assets (Schmidlin, 2014).

Comparison of Business Valuation Methods

Methods/ BV-Asset- MV-Market- FV- Cost of Liquidity

Criteria based based Income- capital approach
approach approach based approac
approach h
Basis of Book/ Market/ Future Capital Acid
method historic comparable estimate costs test/liquidi
value transaction serves as serves as ty value
serves as value serves as the basis. the basis. serves as
the basis. the basis. the basis.
Required Data from Comparable Financial Interest Fast-sale
input data financial data from plans, rate, transactio
statement multiple discount repaymen n data,
s* databases* factor, t schedule salvage
industry and other value
risks * capital informatio
financing n
costs
Need for Only Required for a Special Special Required
experts required in moderate expertise expertise for a
certain extent* required* required* moderate
cases* extent*
Advantage Basic data Simple and Anticipate Explores Provides
s can be quick to carry d tax alternative
easily out* performan implicatio exit or
retrieved*; ce is taken ns of debt capitalizati
Realistic into costs on
(Mercer, account* strategy
2008)
Disadvant Asset Assessing Both time- Provides Negligent
ages value can comparative consuming limited of
be data is costly* and perspecti company’s
influenced costly* ve on the growth
by value potential
measurem
ent
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methods*
Limitation If asset is Limitations Future Cost of Liquidation
s valued at apply in terms business capital prices are
market of accessibility plans are provides difficult to
price, or availability based on limited determine
expert of comparative assumptio perspecti (Schmidlin
involveme data* ns* ve , 2014)
nt is
required*

Note: The above criteria for business valuation methods were adopted

from Szabolcs Szeles, a senior partner at Hungarian business consulting firm

WTS Client and parts with * symbol is in-text citation from the named source

(WTS Client. n.d., p.1).

To conclude, every valuation methods have their own pros and cons

depending on where to use them and at what costs. Managers should make

themselves fully aware of the peculiarities of these approaches and to combine

them for the specific purpose of the needed action, whether it is for any merger

and acquisition, litigation and other purposes.

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References:

Accounting Tools. (2021, April 13). Book value definition.

Accountingtools. https://www.accountingtools.com/articles/what-is-book-value.html

Chan, J. (2021, August, 13). Future Value (FV). Investopedia.

https://www.investopedia.com/terms/f/futurevalue.asp

Dauderis, H., Annand, D., & Jensen, T. (2021). Introduction to financial Accounting. Lyryx

Learning Inc. https://lyryx.com/introduction-financial-accounting/

Fazzini, M. (2018). Business Valuation: Theory and Practice. Palgrave Macmillan. Available at:

https://doi.org/10.1007/978-3-319-89494-2

Luca, P. (2018). Analytical Corporate Valuation: Fundamental Analysis, Asset Pricing, and

Company Valuation. Springer. https://doi.org/10.1007/978-3-319-93551-5

Mellen, C., & Evans, F. (2018). Valuation for M&A: Building and Measuring Private Company

Value. Third Edition. John Wiley and Sons, Inc. New Jersey: Hoboken.

Mercer, Z. (2008). Business Valuation: An Integrated Theory. Second Edition. John Wiley &

Sons, Inc. New Jersey: Hoboken.

Seth, S (2021, January, 17). Book value vs. market value: What's the

difference? Investopedia. https://www.investopedia.com/articles/investing/110613/

market-value-versus-book-value.asp

Schmidlin, N. (2014). The Art of Company Valuation and Financial Statement Analysis: A Value

Investor’s Guide with  Real-life Case Studies. John Wiley & Sons, Inc. UK.

Trugman, G. (2012). Understanding Business Valuation: A Practical Guide to Valuing Small to

Medium Sized Businesses. Fourth Edition. Wiley. NY: New York.

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UoPeople. (n.d.). BUS 5111-01 Learning Guide Unit 5 – Introduction. Retrieved from:

https://my.uopeople.edu/mod/book/view.php?id=307412&chapterid=358904

WTS Client. (n.d.). A comparison of business valuation methods. Retrieved from:

https://wtsklient.hu/en/2019/02/12/business-valuation-methods/