Some methods of valuing businesses
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Business valuation has become an intrinsic part of any investment armory especially if you are considering an investment in an unlisted company in the expectation that you will be able to exit when the company performs an IPO [Initial Public Offering] and offers its shares to the investing public. This is also necessary in a number of different circumstances such as mergers and acquisitions, a complete corporate restructuring or an investment that is being examined by a venture capitalist or an angel investor. All of these activities can only be carried out on the basis of a valuation of some kind so that the true intrinsic value of a business or a company can be accurately established. There are a number of different approaches to valuation and here, we will look at some of the most common approaches and the methods that are used.
The Asset Approach method is generally used for any business which owns tangible assets such as plant and equipment or factory buildings. It is based on the assumption that these tangible assets can be liquidated for cash and what is left after paying off the creditors represents the net worth of the business. In other words, this approach is dependent on the liquidity of the underlying assets and can go wrong if the market value of these assets is incorrectly estimated. This method is also unsuitable for businesses with a large proportion of intangible assets such as intellectual property, brands or patents.
Methods that rely on discounted cash flows are considered to be reliable because they can establish the capacity of the business to generate free cash flow. One common approach in accomplishing this is to calculate the future free cash flow that operations will generate after meeting all the liabilities of the business. This net future free cash flow is generally discounted back to the present value by using an appropriate discount rate. One commonly used discount rate is the weighted average capital cost for the business which is another term for the cost of equity and debt. This weighted average capital cost is then combined with a risk factor called Beta. Because it is not easy to measure risk, Beta is often calculated by using historical data to establish the impact of the previous business cycles on the free cash flow generated by the company.
Another technique that is commonly used to value businesses is called the Price/Earnings ratio [PE ratio]. This is calculated by the price at which the stock of a listed company is quoted divided by the earnings per share. If you can establish this ratio for a listed company, you can also value comparable businesses that are not listed simply by multiplying the net income by the PE ratio. It is an uncomplicated and straightforward method of valuing unlisted businesses without any complicated calculations. It also has the merit of taking into account investor perceptions and sentiment and establishes what the market will be prepared to pay for such a company.
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