Valuing a business is a challenge faced in several legal contexts. In M&A transactions, the buyer and seller will want to know whether a fair price is being paid. In divorce and separation cases, businesses are often treated as marital property and their value must be divided between the spouses. Valuation is an art as well as a science; there are many ways to do it, and none of them are entirely reliable.
Net Asset Value Method
The simplest way to value the equity in a business is to look at its balance sheet, and subtract the total value of its assets from the total value of its liabilities. While this method is very simple and can be performed with relatively little financial expertise, it often grossly understates the value of a business, because most businesses derive value from their future income rather than the value of their assets. The most valuable assets to many technology companies are intellectual property rights, which are not always included on its balance sheet (and may be very undervalued even if they are). A professional practice like a law or accounting firm may not have many assets at all beyond its cash on hand, but may have incredible value in its business relationships and reputation. Even if assets make up the bulk of the value in a business, they may be undervalued on the balance sheet for various accounting reasons.
Discounted Cash Flow (DCF) Method
The DCF method involves making a detailed forecast of the business’s income over the next several years, typically in a large Microsoft Excel spreadsheet, and making many assumptions about the business’s future revenue and expenses. This forecast is used to estimate how much cash the business should generate over time. Those cash flow numbers are then “discounted” to a “present value” based upon the business’s cost of capital (essentially, how much return it would have to provide to lenders or investors based on its risk profile and supply and demand in the market).
DCF valuation is popular among investment bankers, private equity firms, and other financial professionals, and looks like a very scientific method on its face. Its greatest weakness is that it is dependent on the assumptions made by the person creating the model. Nobody really knows how quickly the business will grow (or shrink), what external factors might impact its expenses, or the true degree of risk involved. A proper DCF valuation will generally result in a fairly wide range of fair values based on various assumptions.
Multiples Method
In this method, valuation data is collected for similar businesses and compared to the business’s income numbers to decide how much the market would be willing to pay for a business in comparison to its income. The valuation data may be based on stock prices of public companies, or on reported acquisitions of privately held companies. Because a business’s financing methods have a huge impact on its equity value, this method typically compares income factors to enterprise value (EV), the theoretical amount that a buyer would have to pay to acquire the entire business and pay off its debt. The simplest formula for EV is the market value of the equity in the business, plus the business’s debt balance, minus its cash.
The most popular income factors used in this method are revenue (sales) and EBITDA (earnings before interest, taxes, depreciation, and amortization). Revenue is the business’s “top-line” income — all of the money it takes in before paying expenses. EBITDA is the business’s “bottom-line” income after paying its expenses, but before paying interest, taxes, depreciation, and amortization (these costs are excluded because they vary considerably based on the business’s financing means). EBITDA is generally a more reliable metric, but can only be used if the business is profitable. EV as a multiple of revenue is typically in the range of 1 to 3, while EV as a multiple of EBITDA is typically in the range of 10 to 25. Multiples are largely based on the perceived risk and growth potential in the business. Technology companies, for example, typically have very high valuations in comparison to income.
One of the greatest challenges in applying this method is selecting appropriate businesses for comparison. This often requires industry-specific expertise. Car dealerships, for example, are valued at very different multiples depending on the make of cars that they sell. Gathering financial and valuation data for non-public companies is also very challenging and may require access to non-public databases.