As with goods and services, it is also possible for a company to determine their market value. It is known that the value of a business market does not always coincide with the value of equity balance, investments made or the image of business management as a business value. For example, in a situation where it is planned to sell a business, the valuation of the company must be done before negotiating with a potential buyer. Similarly, in cases where the capital shares of a commercial company are invested in the equity capital of another commercial company as a property investment, an assessment of these capital shares is required. Valuation of a company whose shares are not traded on public stock exchanges is a responsible and complicated process. An appropriately prepared valuation report gives management an understanding of the value of the evaluated company prior to the activity involved in the sale of that company. Business valuation services are used not only by business vendors, but also by people who want to buy a business and make sure that a potential deal will not result in overpaying.
Our specialists have extensive experience in determining the value of the company. We have provided ratings for changes in ownership structure, sales / purchases of shares / stocks, and property investments. Our assessors are registered in the Enterprise Register Business Evaluators database. For questions, please contact us: Artūrs Breicis, tel. +371 29274911, email: firstname.lastname@example.org.
Summarizing the situations where it is necessary or desirable to conduct a business or business valuation, the following cases can be distinguished:
- Mergers and reorganizations of companies;
- Protection of the property interests of owners;
- Capital Shares or Shares Purchase-Sales Transactions;
- Investment and business planning;
- The Enterprise Register for substantive investment in the company’s share capital;
- Sale of capital shares between related companies to demonstrate to the State Revenue Service that the transaction complies with the transfer pricing requirements;
- Business and investment planning.
Below, we provide general information on more commonly used business valuation approaches.
Business valuation approaches
In order to determine an adequate business value for different types of transactions, three basic business valuation methodologies are most commonly used: an asset (cost) approach, a revenue approach and a market data comparison approach.
Asset (cost) approach
The asset (cost) approach is applicable to situations where an entity acquires the highest value as a result of a possible sale of assets, rather than using its revenue potential. In this approach, the enterprise value is determined according to all costs associated with the creation of the company. Consequently, this approach results in the determination of the amount of all costs that would arise if a company equivalent to the company under assessment was re-created. The asset (cost) approach includes two methods:
- Net asset method;
- Method of liquidation value
The net asset method is used in cases where the value of an enterprise is heavily influenced by material property contained in it, the added value of employees for the products or services provided by the company is small, the intangible assets owned by the company are insignificant or the company has recently been founded. As part of this method, it is intended to determine the market values of assets and liabilities, while the difference between the market values obtained is the current market value of the valued company. Attention should be paid to whether all assets and liabilities are included in the balance sheet, if not – adjustments must be made. This approach is rarely applied in business valuation practice. The liquidation value method results in an amount that the business owner would be able to obtain if the company’s liquidation would result in the sale of all of the company’s assets and liabilities. This method is used by companies that have become insolvent or have become seriously challenged by the company, the value of the company in case of liquidation is higher than it is continuing or a decision is made to liquidate the company.
Market data comparison approach
This approach requires the company’s market price to be determined according to the value that buyers are willing to pay for a similar company. Consequently, the value of the company under assessment is compared with the prices of other equivalent companies in the market or with certain indicators in the respective sectors. There are three methods for this approach:
- Transaction or Transfer Method;
- Sector coefficient method;
- Method of publicly quoted companies.
The transaction or transfer method is based on the available market information, on the identification of the various multiplier bases and on the calculation of the enterprise value using these multipliers. The following multipliers are identified:
- Profit and cash flows;
- Balance values.
The transaction or transfer method is based on the use of two types of information – market price or use of financial information. The sector coefficient method determines the value of the company, according to the sector in which the company operates. The financial performance of the rated entity is multiplied by a factor , specific to the industry. This business valuation method is used relatively rarely due to the fact that a large amount of comparable data in the sector is required and that data is not always relevant. As part of the method of publicly quoted companies, one or more equivalent companies in the same sector are selected which are listed on the stock exchange, so that information on changes in the stock market prices of these companies is available. After such companies have been found to determine the appropriate value of the companies under assessment, adjustments are made to take into account the size of the company, the specific nature of the products/services offered, etc.
The revenue approach is based on the assumption that the value of a business is closely related to future earnings. Under this approach, a potential investor will not pay a higher amount for the valued company, while the owner will not sell for a smaller amount, as will the current value of the company’s future generated earnings. This approach is used in company valuations that are not planned to be eliminated. The revenue approach includes revenue capitalization and revenue discounting methods. The revenue capitalisation method is used when it is assumed that the activities of the company under assessment will be in line with the company’s current activities in the future and that the company will have a normal growth rate. The future performance of the company under assessment is forecast according to the performance of previous periods. This projected profit is discounted to obtain the company’s market value. The method of discounting revenue, or the discounted cash flow method, can be used to evaluate any business, but it is recommended that this method be selected for a company whose future activity may be different from that of the company. Using this valuation method, the income to be generated for each future period is calculated separately. This income is discounted using the present value method. Two options can be used to determine the discount rate – Capital Assets Pricing Model , focusing on risk factor analysis or Weighted Average Cost of Capital, focusing on the structure of capital and capital prices. As the method of discounting revenue is one of the most commonly used methods for evaluating companies, this method will be discussed in more detail below.
The use of discounting revenue method
The discounting of revenue or discounted cash flow method is based on discounting forecasted cash flows in order to obtain the current value of forecasted future cash flows. When using the discounted cash flow method, a company’s expected cash flow is usually generated for at least 5 years. This period may be extended depending on the sector in which the company operates, at what stage of development and whether it is possible to predict the financial performance of the enterprise. Predicted cash flow over this period as well as the estimated cash flow value after these 5 years or terminal value is discounted with Weighted Average Cost of Capital rate. To determine the value of a company, the present (discounted) value of the estimated cash flow is summed with the discounted terminal value, which serves as the basis for the use of the discounted cash flow method. In order to assess a business using the discounted cash flow method, it is usually necessary to take the following steps:
- Step 1: Assessment of the company’s actual and forecasted future performance indicators;
- Step 2: Completing Free Cash Flow;
- Step 3: Weighted Average Cost of Capital calculation;
- Step 4: Determination of terminal value;
- Step 5: Calculate the Present Value.
Step 1: Assessment of the company’s performance indicators
As part of this first step, it is necessary to obtain and collect as much information as possible about the company and the industry in which it operates. It is necessary to identify the main factors and conditions that have an impact on the company’s financial and performance indicators. Certain factors serve as auxiliary information in the process of drawing up free cash flows.
Step 2: Completing free cash flow
The free cash flow is the cash flow available to the company at the end of the financial year. You can see the display of the free cash flow calculation below. Calculation of free cash flow:
Profit or loss before tax and interest payments Minus (-): Taxes
Profit or loss before interest payments Plus (+): Depreciation (amortization) Minus(-):Capital Expenditures Minus (-):Net Working Capital
Free cash flow
Historical information such as growth rates, profit margins and other factors that describe the company’s activities should also be taken into account in order to make a free cash flow forecast. This future cash flow should determine when financial results reach a stable rate/rate of increase. Normally, it is assumed that a normal growth level/rate is reached over a period of 5 years, and the company is surviving at least one business cycle, and has been implemented in the past, as well as new activities have been launched.
Step 3: Weighted Average Cost of Capital calculation
The WACC is a globally accepted standard used as a discount rate to calculate the present value of the company’s projected free cash flow and terminal value. This rate reflects the required weighted average return on invested capital in a given company. The formula for calculating the weighted average capital price rate is to be considered below.
WACC = Debt price after tax * Share of debt in total capital + equity price * Share of equity in total capital
WACC = rd * (1 – t) * D / (D + E) + re * E / (D + E)
rd = debt usage price
re = the cost of using own capital
t = corporate Income Tax Rate
D = market price of company liabilities
E = the market price of the company’s equity
The WACC is usually determined using 3 approaches and further defining the average WACC.
WACC according to total capital return
To determine the average capital price, the average return on capital in the sector is determined, assuming an investor expects a similar return on the company, as in the industry. The industries average return on capital is determined on THE basis of AMADEUS data.
WACC according to return on equity
To determine the average capital price, the average return on equity in the industry is determined, assuming that the investor expects a similar return on the capital of the valued company as well. Using the above-mentioned AMADEUS selection, a median return on equity (net return on the company’s equity) is determined by further determining the average return on equity.
WACC according to CAPM
Since the above approaches rely more on the carrying amount of own funds than on market value, approach 3 uses the so-called CAPM model, or the capital asset price valuation model. The CAPM is based on the premise that investors should receive a certain reward for taking market risks in the form of a risk premium, or an additional return above a risk-free return on investment. The equity price was therefore determined according to the following values:
- Return on risk-free investment, say 2.9% (below A) or long-term issue of bonds released by the Republic of Latvia;
- Excess of expected return on risk-free investments (further B), measured by reducing the average return on equity previously calculated on the return on risk-free investment (2.9%);
- Beta, which is determined according to publicly available information for the industry and describes how the stock prices of this sector correlate with changes in the common stock market. The industry beta is further adjusted according to the capital structure and tax rate, resulting in an adjusted geared Beta;
- An additional expected return is determined using publicly available data.
On the basis of these data, an equity price is determined using the following formula:
Equity price = A + geared beta * B
The WACC rate is then re-established using the above-mentioned WACC determination formula and pre-determined data on the average share of borrowed capital.
Step 4: Determination of terminal value
The discounted cash flow method in the valuation process is based on the present value of the company’s expected cash flow. Since it is not possible to predict the free cash flow of an enterprise for an indefinite period of time, it is necessary to evaluate the value of cash flow after the end of the forecast period or the so-called terminal value. In practice, 2 methods for measuring terminal value are commonly used:
- Method based on multiplication of the last forecast annual income by a certain industry factor;
- The method based on the assumption that the last year’s cash flow will continue for an unlimited period
Depending on the situation, one or even both methods may be used to determine the terminal value.
Method 1 : Multiple Method
The Exit Multiple method reflects the amount of free cash flow of the company after the end of the forecast period based on the annual EBITDA of the terminal. The calculation formula is shown below:
Exit Multiple Method
Terminal value = EBITDAn * Exit Multiple
where: n = forecast period (annual number)
Method 2 : Perpetuity Growth Method
When determining the terminal value using Method 2, it is assumed that cash flow income will increase evenly each year, while discounting it according to the already established average WACC rate (see formula below). Consequently, in the evaluation process, the valuer should decide on the basis of an assessment of the current situation what the increase rate will then be. This rate of increase is usually chosen according to the expected long-term growth rate of the industry, which is usually between 2% and 4%.
Formula for calculation of terminal value
Terminal value = vērtība = FCFn * (1 + g) / (r – g)
FCF = forecasted free cash flow
n = last year of the forecast period
g = accepted growth rate
r = WACC
Step 5: Calculate the Present Value
The present value calculation is made by discounting the free cash flow for each year, including the terminal value, with a discount coefficient determined according to the following formula:
Formula for calculating discount coefficient
Discount coefficient = 1 / (1 + WACC)n
where n is the forecast period (annual number)