There are many methods available for valuing a business. Each one addresses valuation from a different perspective, which results in a range of possible valuations. An acquirer will likely attempt to use a valuation method that yields the lowest possible price, while the seller will want to use a different method that yields a higher price. In the following bullet points, we begin with valuation methods that yield a low valuation, and work up to methods that result in higher valuations. The methods are:
- Liquidation value. This is the amount of funds that would be collected if all assets and liabilities of the target company were to be sold off or settled. Generally, liquidation value varies depending upon the time allowed to sell assets. If there is a very short-term “fire sale,” then the assumed amount realized from the sale would be lower than if a business were permitted to liquidate over a longer period of time.
- Book value. Book value is the amount that shareholders would receive if a company’s assets, liabilities, and preferred stock were sold or paid off at exactly the amounts at which they are recorded in the company’s accounting records. It is highly unlikely that this would ever actually take place, because the market value at which these items would be sold or paid off might vary by substantial amounts from their recorded values.
- Real estate value. If a company has substantial real estate holdings, they may form the primary basis for the valuation of the business. This approach only works if nearly all of the assets of a business are various forms of real estate. Since most businesses lease real estate, rather than owning it, this method can only be used in a small number of situations.
- Multiples analysis. It is quite easy to compile information based on the financial information and stock prices of publicly-held companies, and then convert this information into valuation multiples that are based on company performance. These multiples can then be used to derive an approximate valuation for a specific company.
- Discounted cash flows. One of the most detailed and justifiable ways to value a business is through the use of discounted cash flows (DCF). Under this approach, the acquirer constructs the expected cash flows of the target company, based on extrapolations of its historical cash flow and expectations for synergies that can be achieved by combining the two businesses. A discount rate is then applied to these cash flows to arrive at a current valuation for the business.
- Replication value. An acquirer can place a value on a target company based upon its estimate of the expenditures it would have to incur to build that business “from scratch.” Doing so would involve building customer awareness of the brand through a lengthy series of advertising and other brand building campaigns, as well as building a competitive product through several iterative product cycles.
- Comparison analysis. A common form of valuation analysis is to comb through listings of acquisition transactions that have been completed over the past year or two, extract those for companies located in the same industry, and use them to estimate what a target company should be worth. The comparison is usually based on either a multiple of revenues or cash flow.