There are several reasons a stakeholder would like to know your company’s valuation. There are times when the government or any other legal body seeks to understand the worth of your organization.
Accurately calculating the valuation of a business is a mix of science and art and helps people take requisite steps related to the company.
This article discusses popular ways and how to calculate business valuation via the stakeholder in Singapore.
What do we understand by the business valuation process?
Business valuation is the process of determining the economic value of a unit or the entire business of the organization. Companies in Singapore are often on the lookout to understand several aspects of their operations, and gauging their economic value helps them garner the requisite insights.
There are several ways to determine the value of a business, and most of them cater to different case scenarios.
For example, if you are looking to sell a unit or the business in its entirety, discounted cash flow is usually the most common valuation method used. Whereas for valuing real estate business, the asset-based valuation is often more suitable.
Why do we need a business valuation?
When we invest in gold, we always look at its prevailing prices before investing in it. Similarly, for investors interested in investing in a business, it is imperative for them to know about its worth before making a move.
In many cases, creditors also forward credit to entities only after understanding their valuation. It gives them a rough idea about the business’s ability to repay the debt.
The company itself uses valuation for a variety of purposes –
Acquiring or getting a stake in some other businesses or selling their businesses
A business often looks for vertical or horizontal expansion. Like any other investor, they look for an accurate valuation to gauge the right price for the stake they are looking to acquire. Even in cases where they are looking to offload a part of their business or the entire one, valuation will help ensure they do not undersell it.
If your business is applying for funding, it is imperative to have its valuation ready. Most lenders don’t lend on hype and will require an accurate description of your company’s worth.
Adding or buying back shares
If the business is looking to add shareholders or reduce the volume of shares out in the market, it will have to use valuation. It will give a reasonable price so that interested parties are willing to take requisite action.
Top five business valuation approaches
The business valuation takes into account the company’s management, its revenue potential, the market value of the asset, capital structure, or other factors depending on the approach undertaken by the valuer. It often considers peers’ valuations too for valuing the given business.
Below we list five top business valuation approaches and methods used by businesses for ascertaining their worth –
Discounted Cash Flow (DCF) Analysis
The most common and the most versatile, the discounted cash flow (DCF) approach, uses intrinsic valuation to estimate the current value of an organization or its business unit. It assumes that the going concern approach holds good and uses the purported future cash flows to assign a value.
Here are its key components –
A projection period
It refers to the time frame the valuation covers (for example, 10, 15, or 20 years). Generally, most businesses move through three key phases –
- Diminishing growth
- Stable growth
Most businesses utilize DCF to value themselves in the usual scenario until they reach a stable valuation phase.
Stable cash flow
It is the cash flow that the company expects every annum once its growth stabilizes.
DCF uses the pullback method, i.e., it pulls back the future cash flow to their present valuation to ascertain the business’s current value. So it requires a discounting factor or a percentage (say 10%) to pull back all the future cash flows to their present value.
How is business valuation calculated using the DCF approach?
We pull back every year’s expected cash flow to find out the present value of the business if these projections hold true.
Here is its basic formula –
Present value of cash flow = Cash flow/(1+discount rate)^projection period
But you can only use it if the growth has stabilized. If the company believes that it has a varying growth rate for the next few years, each year’s cash flow has to be pulled back separately.
Capitalized excess earning method
As the name suggests, the capitalized excess earning method uses the “extra” income generated by the business to ascertain its valuation. Let us explain.
Depending on the sector it belongs to, every company is capable of earning a certain amount from a specific level of net tangible assets. But there are other factors that often propel the organization to earn higher returns.
Even though this method was never intended for business valuation, its simplicity has made it popular as one. Here are the steps to calculate it –
- Calculate the net tangible assets of the business/division to be valued
- Multiply the figure by the expected rate of returns (ERR) to find the average returns (A)
- Calculate the company’s total earnings (B)
- Subtract (A) by (B) to reach excess earnings figure (C)
- Divide (C) by an appropriate capitalization rate to find the value of the business/division
Replacement value method
Also known as the substantial value method, the replacement value method is an asset value approach. Here, the valuation takes into account the amount needed to replace the existing company assets for reaching a value.
For example, if land and building stand at SGD 10,000 in your latest balance sheet, but upon inspection, you found that it is valued 20% more in the market. So as per the replacement value method, land and building value will be increased to SGD 10,000*120% = SGD 12,000.
Similarly, if your creditors’ balance stands at SGD 5,000 in your balance sheet, but 60% of your creditors are willing to waive off 50% of their dues. So as per replacement value method, your current value of creditor will stand at (SGD 5,000*60%*(100-50)% + SGD 5,000*(100-60)%) = SGD 4,000.
Market value method
The market value method uses comparable data to value the business, i.e., it uses data of its peers that are similarly placed in the market for valuation. Its basis is that an investor would often weigh the value of its competitors before investing in a given business.
So this approach provides a precise understanding of how the company is performing compared to its closest competition.
It uses either of the three data avenues to ascertain the value –
- Publicly traded similar company data
- Sales of interests in a competitor entity
- Sales transaction of peers
But it has become increasingly challenging to value a business based on any of these parameters as the landscape has become far more versatile, and there are a number of aspects involved. Also, this approach is applicable only in cases where numerous similar companies are available for a valuer to compare.
Cost value method
Also known as the asset approach, it uses the assets’ historical value to ascertain the company’s value.
For this, it uses the values presented in the balance sheet and does not take into account future projections. It is the reason people often do not rely on it entirely for making their financial decisions.
Here, the valuer restates the assets and liabilities presented in the company’s latest balance sheet to their fair value. It is because assets and liabilities shown in the face of the balance sheet rarely represent their actual prevailing value in the market.
It is an excellent approach for tangible asset-heavy or real estate businesses where cash does not form a significant part of valuation purposes.
Which model is the best?
Even though every approach has its pros and cons, it is obligatory to understand that they would be more suitable for specific business and company types.
For example, an asset-heavy business would prefer the cost value process, whereas a company that expects strong growth would be happier with DCF.
Valuation is a broad field, and businesses in Singapore are too versatile to follow any of these approaches with their eyes closed. So you will find a great number of organizations falling in each of these categories and swearing by one or the other for their business decision making.
It is also crucial to realize that valuation by each of these techniques may give significantly different results. So a business must ascertain which of these resembles the real-life value of them the closest and accordingly adjust periodically to ensure an improved understanding of themselves and their operations.