Just like any other investment, getting a business is never different. Everyone is entitled to doubt the company, thinking if the venture is worthy of time and money.
Is it weird? No. It is always a normal thought.
But, there are always ways to help you decide on this fast and easy, like doing a business valuation.
If you are unfamiliar with this concept, this guide is for you.
What is a business valuation?
Investopedia has a very straightforward definition of business valuation.
It is a general process of determining the economic value of a whole business or company unit. At the same time, it is used to determine the fair value for different reasons, aside from the objective estimate of the company’s value.
In entrepreneurship, business valuation is the process of estimating the value of a business so you can determine if the investment is worthy of the capital. Moreover, it is one way to check if the amount is fair and how much of it you can negotiate with.
Another thing to remember about business valuation is the fact that it is subjective. What seems to be fair for you may not be acceptable for others.
While the idea of business valuation is almost the same across different investments, you should bear in mind that there can be slight differences at times, especially when dealing with stocks or real estate.
How does it work in the Philippines?
Business valuation in the Philippines is somehow dominated by the idea of letting professionals do it on behalf of you.
However, it should not always be the case because you can do it by yourself. All you need to know is to understand how it works, including the legalities associated with it.
Consider this as a skill that you can use in the long run, especially if you are buying or selling a business or even shares in the company.
Business Valuation: 3 Phases to Learn
If you are interested in venturing and learning business valuation, you should understand the three stages.
1. Industry-specific expertise
Being an expert in the field matters. In the long run, you will know that this expertise is important when determining the estimated value of a property, business, or stock. Hence, being the master in forecasting assumptions and domain expertise cannot be overlooked.
For example, each business valuation differs from one industry to another. The data applicable for the fast-moving consumer goods industry is not always the same when it comes to the automotive industry.
Therefore, having that competitive advantage based on your expertise is always a weapon you can use to be the first in the field.
2. Due diligence
Sometimes, when you do a business valuation, some information is not provided to the public at all.
In this case, due diligence is a significant part of the process. Simplified, it is the process of verifying the accuracy of information from the management, whether it is known publicly known or not.
Remember that valuation only becomes relevant when the information you have is also significant.
3. Actual Business Valuation
At this phase, you already have all the information you need to do your valuation. However, if you think what you have is not enough, try securing the company’s financial data that you are interested in.
Otherwise, you can work on the current data and improve them later on as you progress through the process.
Business Valuation Methods vs. The Preferred Method
After learning all the phases, now is the time to learn about the methods.
There are three known valuation methods that you can use:
- Cost Approach
- Market Approach
- Income Approach
But what are these methods all about, and how to utilize them? Check these.
With the cost approach, you are typically dealing with the net assets of a business.
On the other hand, the market approach refers to the estimates with values based on the price multiples. A typical example is the price-to-earnings ratio of similar listed companies. From there, you can examine the data and get strong data.
Moreover, the income approach estimates the value based on the potential future income of the company.
The Preferred Method
Given this, what is now the preferred method? Any wild guess?
Well, given the previous approaches, it makes sense to consider the income approach as the preferred method.
Even if some argue that it is not, there are many ways to prove that this approach is justified.
If you compare the cost and market versus the income approach, you can conclude that the former only considers the production costs by the time of the valuation.
However, the income approach is different. Instead, it examines the future income you can get from the company, which is always the ultimate goal.
It is like asking yourself, what is in it for me? And, everyone knows that above anything else, profit always matters.
You invest because there are benefits to get out of that investment.
Moreover, this approach estimates the company’s equity by getting the current value of future cash flow due to equity holders, or the so-called Free Cash Flow to Equity (FCFE).
- To simplify the whole process, there are three variables involved here:
- The present value - the amount that is currently in line with the current valuation
- The free cash flow - aside from the profits, you need to consider the cash flow of the company to ensure that at one point, it can pay its debt or distribute dividends.
- The FCFE - is the free cash flow available to equity holders and is adjusted for debt repayments and issuance of new debt.
The Alternative Method
At the same time, if you are not convinced of this method, the market approach can be a good alternative.
For going-concern businesses, it is another approach to consider because the differences between the company being valued and the others are always comparable. You can always do the math after.
So, what is the flow?
Well, by theory and practice, the income approach is used to estimate the range of values while the market approach checks the validity of the given content. You just have to ensure that you understand that part.
Forecasting and the FCFE Computation
Now, it is time to learn about forecasting.
The standard practice in the industry is to get a forecast for the next five years. Then, you need to assign an ending value that is equal to the sixth year and beyond.
At the same time, here is the FCFE computation.
Start with net income, free cash flow to the firm, or the cash flow from operations using the following:
FCFE = NI + Dep – Capex – Change in WC + Net Debt
FCFE = FCFF + Net Debt – Interest x (1 – t)
FCFE = CFO – Capex + Net Debt
Confused? No problem. Here are the legends to guide you through.
FCFE = Free cash flow to equity
NI = Net income
Dep = Depreciation & amortization
Capex = Capital expenditure
WC = Working capital
FCFF = Free cash flow to the firm
t = marginal tax rate
Lastly, refer to these steps to get the final values.
For the FCFE, plot the future per year and discount them back as of the valuation date.
Next, the discount. Well, try not to confuse yourself with the usual connotation of discount. Instead, think of it as the process of getting the present value of a future cash flow.
Here is an example:
If you expect to receive PHP 10,000 next year with a discount rate of 10%, then the present value is only PHP 9090.91.
The computation goes like this: PHP 10,000 / (1 + 10%) = PHP 9090.91
If this formula seems complicated, then utilize a spreadsheet. The most typical one is from Microsoft Excel or Google Sheets, which have the formula for “PV” or present value.
In the end, business valuation remains a valuable aspect of the whole business process. You need to know this if you want to see the worth of the investment.
Aside from that, it is also an art that helps you negotiate a deal along the way. If you are backed with facts and data supported by economic data, it is never impossible to deal with business owners.
Through this, you can always save more money in acquiring the business through a persuasive method.
So, yes! If you doubt whether or not you should do a business valuation for your business or before any business acquisition, then free yourself from the worries!
It is always a good idea to do this and a highly recommended strategy that benefits you in the long run.
Otherwise, try checking out as well the list of franchises on our website or post your own commercial space posting on our dedicated listing space and start offering them to possible renters.
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