Challenges and the ways out for business valuation models

Generally, there are four popular valuation models:

1. Discounted Cash flow (DCF) model
2. Relative valuation model, and
3. Asset base valuation model
4. Earning Capitalization model

Let’s start with DCF model.

For raising equity or other finance from any other sources, valuer uses this model. Valuer heavily relies upon the expected future cash flows as communicated by the management. But the valuer should reduce the future expected cash flows because the management may be biased (it has to raise funds). These cash flows are estimated for a certain time period, say 3-5 years. After that, these cash flows are discounted at a well-estimated discount rate. Cash flows may be Free Cashflow to Firm (FCFF) or Free Cash Flow to Equity (FCFE). Of course, this valuation model is used as a going concern.

Where are the loopholes?

• Expected future cash flows are prone to change due to various factors such as competitors’ strategy, technological changes, brand dilution, change in management strategy etc.
• How to fix up the discount rate? It is also subject to change over years. Also, there are many factors which affect the discount rate and these factors are unpredictable.

The way out…………

• Do sensitivity analysis by changing the cash flows and the discount rate.
• Value your business frequently whenever there is the change in external or internal situations.

Now, let’s have a look at relative valuation model:

This model is used to value a business in relation to similar business. Earnings and/or cash flows of the business undervaluation is compared with those of the similar business and with the help of the given price of the similar business, the price of the business undervaluation is estimated.

The difficulty is that:

• Whether the similar business operates in the same products, markets
• Whether the similar business uses the same technology
• Whether the similar business is as old as this business
• Whether price/value of the chosen similar business is unbiased etc.

The way out……..

• It is better to choose the very close similar business which operates in the same market and has very similar product.
• Choose more than one similar business and if possible compare the business with the industry average.
• Adjust the price/value of the similar business upward or downward

3rd comes Asset Valuation model

Many people believe that this valuation cannot be used for going concern businesses. Partially true. This model can be used for those businesses also but there must be significant productive assets. It includes R&D, IP, TM etc also.

The difficulty is that how the productive assets can be valued and what is the expected life of those assets.

The way out is that asset valuer should value those assets at expected market value and asset value and the expected life of the assets should undergo sensitivity analysis.

The last popular model is Earning Capitalization model:

Under this method, Equity earning is capitalized at a certain rate. This model assumes that the present earning shall remain fixed forever.

The loopholes:

• This model does not consider growth in the business.
• The rate at which earning is capitalized is prone to change

The way out:

• Consider the average earnings for last 3-5 years.
• Calculate the average growth in earnings for last 3-5 years and estimate it for next 1st future year and then capitalize it.
• Do sensitivity for earning, growth rate and the discount rate.

To conclude, no valuation model is full proof. To value any business, valuation models in combination should be used.

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