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Methods/Approaches To Valuation

Methods/Approaches to Valuation
There are various approaches to the valuation of a business. The major ones are:
  • Asset-based approach to valuation

  • Earnings based approach

  • Market value based approach

  • Fair value method

  • Asset - based approach to Valuation

  • This approach aims at determining the value of net assets. Assets can be valued at their book value, market value, replacement value or liquidation value and this method determines the basis of assets valuation.
    Net assets = Total assets - Total external liabilities
    Net assets per share = Net assets/Number of equity shares issued & outstanding.

  • Earnings based approach to Valuation

  • The earnings based approach to valuation is on the proposition that the business valuation should be based on future earnings or the firm's capacity to generate cash flows. Thus, this approach eliminates the limitation of the asset based approach which totally ignores the firm's potential to generate cash flows and earnings. Earnings can be measured on two bases:

    • Earnings measured by accounting and
    • Earnings measured by cash flows.

    The value of the firm based on earnings measured by accounting can be expressed as:

    Value = ∑t=1 (Cash flows to firmt/ (1+k0)t

    Where ko = appropriate discount factor, t= time (years till infinity)

  • Market value based approach to Valuation

  • The market value approach is one of the most widely and frequently used in calculating the value of a business, especially, the larger listed companies. The market values of the company's securities are used for this purpose. The market values assigned could be either a) 12 months average of the prices prevailed in the stock exchange, b) the average of the low and high security values during a year or c) any other acceptable fair method of averaging can be used. This method is widely used and is justifiable because market values reflect the investor's consensus. The disadvantage of this method is that market values can be influenced by speculative factors too.

  • Fair value method of Valuation

  • The fair value method is not an independent method by itself, but is based on averaging or weighted averaging of the results provided by one or more of the above discussed methods. This method gives a balanced figure of valuation but has limited application in business valuation.
Other approaches to Valuation:

A number of few methods have been developed in the recent years to value a business. The two major approaches are:

  • Market Value Added approach (MVA)

  • The MVA approach measures the change in the firm's equity market value as a result of a change in the equity investment which consists of common stock capital and retained earnings.

    MVA = Market value of firm's equity - Equity capital investment.
    MVA can also be measured from the point of providers of all invested funds like debt and preference capital.

    MVA = [Total market value of firm's securities - (Equity shareholders' funds + Preference capital + Debt.

    MVA approach cannot be used for all types of companies and can be used only by the firms that's market prices are available.

  • Economic Value Added Approach (EVA)

  • EVA denotes the difference between the total cost of funds and the operating income after taxes. It is totally based on the past performance of the company. The principle upon which this approach is based is that whether the firm is earning a higher rate of return on the invested funds, than the costs of acquiring it. The cost of acquiring the funds is measured by the Weighted Average Cost of Capital (WACC).

    EVA = Net operating profits after taxes - (Total capital x WACC)

    If EVA is positive, it implies that the company is adding to the wealth of the shareholders. If the EVA is negative, it implies that the company has eroded the existing value of the shareholders.

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