The need for company valuation may arise in different situations. As with other assets, the valuation of a business becomes important when the sale of a part or the whole of the company is contemplated. During the sale of a company, the determination of the value of the business and the methods used are critical factors that often influence the course of transaction negotiations.
The involvement of shareholders is also of paramount importance, as it is necessary to know the current and expected value of the company in situations such inviting investors, going public with the company, or launching an employee stock ownership plan.
Other cases where a company valuation may be necessary:
The establishment of joint ventures: when two or more companies decide to jointly establish a new business, the parties involved must determine their stakes and contributions in the joint venture. In such a case, company valuation helps the parties involved to determine the value of each share or quota, which forms the basis of their cooperation agreement.
Various M&A activities (such as mergers or acquisitions): mergers and acquisitions involve companies combining their resources or one company taking over another. In such a case, the current value of the companies can be determined, on the basis of which a business agreement is drawn up and the shareholders involved are fairly compensated.
Determining executive bonuses linked to company value: executive bonuses is another area where company valuation plays a role, as bonuses awarded on the basis of executive performance are closely linked to the performance and value of the company.
The use of ownership share as collateral or security: when equity in a company is used as collateral or security in the course of borrowing or other business transactions, company valuation is used to determine the value of the given ownership share to ensure an accurate and fair transaction.
A company valuation may be necessary for accounting and tax purposes: in meeting accounting and tax requirements, a valuation of the company or certain elements of it may help the business to comply with regulations and to account correctly for taxes and accounting obligations.
The importance of antecedents in company valuation
When determining the value of a company, it is essential to review the ownership structure and financial ratios, with a particular focus on past performance. An analysis of financial ratios and growth – the nature of which may vary between industries – can provide insight into the company’s past performance. Industry benchmarks provide an additional basis for comparison when assessing the performance of the company under review against similar industry groups.
Company valuation in practice
The determination of company value involves a number of aspects, and different valuation approaches need to be used to understand transactions and company performance.
Determining company value:
Setting objectives: In the initial phase of the valuation, it is of paramount importance to clarify the objectives. The role of subjectivity in the interpretation of risks is emphasised and the differences in the perspectives of seller and buyer must be taken into account.
Managing risks: Financial institutions often apply strict risk management rules, which can affect valuation. For example, the shares of a high-risk start-up may be calculated at a lower value than, for example, for a professional investor.
Global market situation: The current global economic environment and market trends are also significant factors. These can affect the position and value of a company.
Company position and performance: An analysis of the company’s market position, successfulness, brand value, and related news is crucial in the course of the valuation.
Plans and expected future performance: The company’s future plans and their feasibility also influence the value. Future prospects can affect the value of a company.
Due diligence: In addition to the application of valuation models, conducting a due diligence process is essential. This is a screening of internal processes to identify how these factors may affect the valuation of the firm.
Company valuation in practice
Valuation methods include income-based, market-based and cost-based approaches, which are briefly described below.
The discounted cash flow (DCF) method is the most common income-based approach. The method has the advantage of using real time values, taking into account the changing value of money over time. The DCF method calculates the discounted present value of a company’s future cash flows, providing a realistic picture of expected returns and expectations of cash flows.
In this approach, market data and prices of identical or comparable companies or transactions are used to determine the value of a company. Comparability and the selection of appropriate multiples are of particular importance in this approach.
The cost-based approach looks at what it would currently cost to replace a given asset. Although often confused with the replacement cost approach, this valuation method is more general and can be particularly useful, especially for early stage or start-up businesses. Here, comparisons with other businesses are difficult to make, or the designs are so subjective that it would be challenging to make a reliable estimate.
The accounting of business value or goodwill is of paramount importance in business transactions such as share purchases, mergers or amalgamations. The value of the shareholding is recorded in the accounts at the same amount as the purchase price paid, even if this amount includes the business value or goodwill. In the case of a merger or amalgamation, existing holdings must be eliminated against equity, which may in some cases result in a significant loss of capital, especially if the assets of the dissolving (merged-in) company cannot be revalued proportionately.
In such cases, the company valuation is conditional on the revaluation also of the assets affected by the company value in the course of the merger. The purpose is to ensure that company value reflects only the excess of the market value of the assets and liabilities over the proportionate share of the market value of the assets and liabilities. The use of this method helps to ensure that the books reflect the true value of the business transactions and minimises potential capital losses in the recognition of any impairment losses.
Determining the value of the business or goodwill, together with the revaluation of the assets involved, is essential in the accounting process. Accurate accounting of the real values of business transactions contributes to a more realistic and accurate representation of financial data. It also helps to minimise potential capital losses, particularly in cases where a detailed and accurate accounting approach to impairment accounting is required.