The Major Methods of Company Valuation
The process of determining the economic worth of a company is known as company valuation (Chen, 2022). This is normally accomplished by estimating the business’s future cash flows and then discounting those cash flows to their present value. Businesses use valuation to evaluate the cost of purchasing or merging with another company, the fair value of stocks and other financial instruments, or the worth of a firm for tax or other purposes (Financial Planning Association, 2020).
The Asset-Based Approach, the Income/Earnings Income Approach, and the Market Approach are the three basic approaches for valuing a company (Ward, 2021). This paper will go through each of these methodologies, explain market capitalization, book value, and predicted future profits, and evaluate their benefits and drawbacks.
Asset-Based Approach
According to BizFluent (2018), the Asset-Based Approach is a way of evaluating a business that considers the value of its assets less the value of its liabilities. This method is commonly used to assess the worth of firms with physical assets such as real estate, machinery, furniture, equipment, inventory, and accounts receivable. This method is also used to value intangible assets such as patents, trademarks, copyrights, and goodwill. This method is based on the idea that the value of a company is equal to the sum of its assets minus its liabilities.
Income/Earnings Income Approach
The Earnings/Income The Income Approach is a way of valuing a company based on its profits in the past, present, and/or future. This method is commonly used to appraise enterprises that provide a consistent stream of earned money. This method assumes that the value of a company is equal to the sum of its future cash flows discounted to its present value (Ward, 2021).
Market Approach
The Market Approach is a way of valuing a company that is based on the values of comparable companies that have recently sold or are currently on the market. This method is commonly used to value enterprises that are comparable in size, industry, and location. This method is based on the idea that the value of a firm is equal to the market price for similar enterprises (Business Valuation Resources, 2019).
Market Capitalization
According to Fernando (2022), Market capitalization is a way of evaluating a company based on its current share price and number of outstanding shares. This method is commonly used to appraise publicly listed firms. This method assumes that the value of a company is equal to the market price of its shares multiplied by the number of shares outstanding.
Book Value
Book value is a way of evaluating a company based on its net assets, often known as book value. This method is commonly used to appraise privately held businesses. This method is based on the concept that the value of a company is equal to its net assets less its liabilities (Hayes, 2022).
Expected Future Earnings
The process of valuing a company based on its predicted future earnings is known as expected future earnings. This method is commonly used to appraise companies with great growth potential. This method assumes that the value of a company is equal to the sum of its predicted future profits discounted from its present value (Financial Planning Association, 2020).
Comparison
Each of the primary approaches of valuing a company has advantages and disadvantages. The Asset-Based Approach is a simplistic strategy that is simple to learn and can be used to almost any sort of organization (BizFluent, 2018). However, this technique ignores the potential for future revenues and does not represent the business’s existing market worth (BizFluent, 2018).
The Income/Profits Income Approach is a more comprehensive strategy that considers the potential for future earnings and is more indicative of the business’s current market value (Ward, 2021). This strategy, however, can be difficult to apply and is restricted by the availability of solid financial data (Ward, 2021).
The Market Approach is a relatively simple and straightforward method that is reflective of the current market value of the business. However, this approach is limited by the availability of comparable businesses that have recently been sold or are currently on the market (Business Valuation Resources, 2019).
The Market Capitalization, Book Value, and Expected Future Earnings methods all take into account the potential for future earnings and are reflective of the current market value of the business. The Market Capitalization method is relatively simple and straightforward and can be applied to publicly-traded companies (Financial Planning association, 2020).
The Book Value method is more complicated and takes into consideration the business’s net assets. This strategy, however, can be difficult to adopt and is restricted by the availability of solid financial data (Hayes, 2022). The Expected Future Earnings approach is straightforward and relatively simple, and it may be used by organizations with strong development potential. However, this strategy is constrained by the scarcity of solid financial data and the difficulty of forecasting future revenues (Ward, 2021).
Conclusion
To summarize, each of the basic approaches to valuing a firm has advantages and downsides. The Asset-Based, Income/Earnings Income, and Market Approaches are all pretty easy and uncomplicated approaches that may be used for almost any sort of organization. The Market Capitalization, Book Worth, and Expected Future Profits techniques all include future earnings potential and represent the current market value of the company. However, each of these methodologies has advantages and downsides that should be carefully evaluated when choosing a firm valuation method.
References
Bizfluent. (2018). Asset-Based Valuation. Retrieved December 13, 2022, from https://bizfluent.com/about-6545017-asset-based-valuation.html
Business Valuation Resources. (2019). Market Approach. Retrieved December 13, 2022, from https://www.bvresources.com/definition/market_approach.php
Chen, J. (2022, September 13). What is valuation? Investopedia. Retrieved December 13, 2022, from https://www.investopedia.com/terms/v/valuation.asp
Fernando, J. (2022, August 10). Market capitalization: How is it calculated and what does it tell investors? Investopedia. Retrieved December 13, 2022, from https://www.investopedia.com/terms/m/marketcapitalization.asp
Financial Planning Association. (2020). Valuing Your Business. Retrieved December 13, 2022, from https://www.fpanet.org/Planning/ValuingYourBusiness/
Hayes, A. (2022, March 10). Book value defined: Meaning, formula, and examples. Investopedia. Retrieved December 13, 2022, from https://www.investopedia.com/terms/b/bookvalue.asp
Ward, S. (2021, June 21). 3 business valuation methods: How to valuate a company. TheBalance. https://www.thebalance.com/business-valuation-methods-2948478
Note:
This article is written based on University of The People Financial Management (BUS 5111) written assignment by Fristy Tania in December 2022
