Question

What are the traditional valuation methods ? How can they be applied to various actual situations? How effective are these methods?

Answer 1

There are three traditional valuation methods of valuing business:

• Asset based approach: asset based approach in turn is classified into two divisions:

5. A going concern asset based approach: this lists the net balance sheet value of its assets & deducts the liabilities.
5. A liquidation asset based approach: this determines the net cash after selling all the assets & paying the liabilities.

This approach seems to be more difficult for valuing a sole proprietorship concern. The asset-based approach is best used when a business is non-operating or has been generating losses, and the company’s focus is on holding investments or real estate.

Earning value approaches: this is a method that is based on the idea that a business’s ability lies in producing wealth in the future. With this approach, a valuator determines the expected level of cash flow on the basis of company’s past earnings, normalizes them for unusual revenue or earnings & the expected normalized cash flows is multiplied by a capitalization factor. Discounted future earnings are another approach where instead of average of the past earnings, trend of predicted future earnings is used & divided by capitalization factor. This is especially useful in making investment decisions. Before investing in a company they want to know how much the company is making in profits. Future earnings are a key factor as the prospects of the company's business and potential growth opportunities are determinants of its stock price. Factors determining earnings of the company are sales, costs, assets and liabilities. The common valuation model used under this valuation is Discounted Cash Flow Method.

Market value approaches: in this approach, the business is valued by comparing it with similar business that has been sold. Market valuation or Relative equity valuation models estimate a stock's value relative to another stock and relies on the use of multiples. A multiple is a ratio between two financial variables. In most cases, the numerator of the multiple is either the company's market price (in the case of price multiples) or its enterprise value (in the case of enterprise value multiples).