Whether you have a business for sale or want to acquire a business, you should do valuation of your business. If company valuation is done properly, you will be able to ask fair market price and increase the chances of getting deal closed quickly. There are various methods used for business valuation such as Capital Asset Pricing Model, Modified Capital Asset Pricing Model and Weighted Average cost of Capital. We have explained here few business valuation method using Income approach to help you understand it.
Valuation based on Income approach demonstrates how to value a company based on its ability to generate desired income or economic benefits to its owners. The financial benefits such as discretionary cash flow or net cash flow is multiplied, discounted or capitalized to perform business valuations. Proper selection of capitalization rate or discount rate or valuation multiples will be the key for effective valuation of your business.
Discounted Cash Flow Method
- It is used to determine present value of the business.
- The discount rate represents the expected rate of return that the buyer has to surrender by investing in business instead of other investments with a comparable level of risk.
- It is calculated based on future projection of cash flow and therefore you have to be realistic rather than optimistic or pessimistic.
- Identify each activity related to revenue generation and estimate future cash flow
- Bifurcate various fixed and variable costs and expenditures.
- Apply appropriate growth rate to the projections. There are two approaches in discount cash flow – Equity Approach and Firm Approach
- Determine future capacity of utilization of business
- Discount rate is arrived by determining the cost of each provider of capital and taking weighted average of that.
Capitalization of Earnings Method
- A capitalization rate is applied in methods of business valuation that are based on business data for a single period of time.
- The capitalization of earnings is particularly useful when the future earnings can be predicted easily and accurately.
Valuation using multiples or relative valuation
It is a method of estimating the value of an asset by comparing it to the values assessed by the market for similar assets. Valuation multiples are the fastest way to assess value, and are useful in comparing similar companies. It could be useful in refining cash flow estimates and testing the reliability of DCF-based valuations. The indication is that similar companies sell at comparable prices.
- Classifying similar assets and finding market values for these assets.
- Transforming these market values into uniform values relative to a key statistic, since the absolute prices cannot be compared. This process of normalizing creates valuation multiples.
- Applying the valuation multiple to the key statistic of the asset being valued, controlling for any differences between asset and the peer group that might affect the multiple.
These are just an overview of the methods for your quick understanding. It is recommended to consult a professional valuation expert for valuing a business.