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2020/11/01

Will you go high by knowing your business valuations based on the stochastic model?

Ali Sadiq

It will really give you much more than what you can expect…!

As an opportunity for Medium-Sized Enterprise, you can choose to do formal valuations for your business ventures, projects, segments, or the whole corporation.

Won’t you prefer the most robust basis for your business valuations?

AM Audit is a versatile consulting firm, having the expertise of the most robust basis of valuation modeling, namely the stochastic valuation models!

Mid-sized businesses often find it challenging to arrive at the right valuations. The causes include missing data, weak assumptions, wrong valuation approach, limited or theoretical scenarios, and similar factors.

What is a Mid-sized Business?

UAE market is segmented broadly into different economic layers, of which Small, Medium Enterprise (SME) forms about 94% of the economy and is segmented into micro-, small- and medium enterprise. A medium-sized business can be traced as having a sales turnover of 200 to 250 million dirhams. Such an enterprise always has a fair chance to expand through internal growth through revenue, usually called organic growth or through some other growth strategy, namely, M&A, diversification, differentiation, expansion cap, or some other means.

Whether you are planning to merge or take over a business, you are restructuring the business processes, making a new investment, or attracting some stakeholders for some business funding. You would need some reliable valuation to present to third parties involved in such a process.

Whether it is a business segment or a new project or a full-fledged group or conglomerate, getting the right valuation will strengthen your pursuit to make a strategic transaction.

Now, before getting into the article, let us have a brief about what precisely the business valuation is?

A valuation is a step-wise assessment of an object’s fair value, which may be a share, a property, a project, a business segment, or a whole of an organization. It is a relatively formal process, which can be defined in the following steps:

  1. Identification of the purpose of the valuation
  2. Determination of the applicable valuation model
  3. Conduct of Due Diligence 
  4. Collection of the Economic Indicators
  5. Definition of valuation model assumptions
  6. Designing a valuation model and behavior of financial modeling
  7. Estimation of the final valuation 
  8. Validation of the valuation estimate

The simplest way of getting a valuation may be done by comparing the company’s physical assets like equipment, real estate, etc. and intangible assets, for example, brand value and trademarks against the liabilities and debts currently owned by the company. However, other approaches may be more suiting depending upon the availability of information and the extent to which the business is organized, among many other factors. Similarly, the value of a company is often influenced by profitability or cash flows.

In a nutshell, business valuations have different ways to measure, besides having a different meaning to different people based on the purpose of such a valuation.

“To effectively measure your business value means to know the essential and non-essential facets of your business and to be objective about what leads to your performance

The Merit of Business Valuations?

As has been said, valuation depends on different bases and perceptions in different scenarios. It makes it difficult for one to understand the real merits one is having in a specific situation. We may present a small list of merits that you will be getting, whether you are a business owner, a CFO, or an investor.

So, we can have a small list of merits of the formal business valuation activity, for example.

  1. Provides a credible figure of business value to the third parties
  2. A basis to conduct different strategic transactions of a business.
  3. An opportunity to review the business information from top to bottom
  4. Some approaches (e.g., discounted cash flows) also provide a long term business plan as a by-product of the valuation process.
  5. Valuation activity aims to assess the market value or fair value of a business on which a company can be sold out.
  6. It provides strategic direction to a business in “go or no-go” decisions.
  7. Various approaches to valuations provide a solution for value in a business in multiple situations and complex scenarios.

This list is not exhaustive and may be extended to many other advantages in different situations.

As for how much you’re expected to do company valuation, it depends on your business. Most analysts would advise you that an annual appraisal is needless for the vast majority of small companies since valuations can be expensive and time-consuming.

However, if the company is your most significant investment, it might not be a bad idea to check your well-being every so often, and a thorough valuation review will do it.

“The critical investment factor is determining the intrinsic value of a business and paying a fair bargain price.”  – Warren Buffet

Understanding how to determine Business Valuation?

Much as there are several explanations for needing a precise business value calculation, there are many approaches to measure the number.

Approaches to Valuation

1. Traditional Approaches

These models of valuation developed based on the most intuitive process one can determine to conduct. These models are based on the assets or profits as they present the conventional way of calculating something’s value. Some of the famous approaches under such valuations are as follows:

i. Assets-based Valuation (Going Concern)

This method gathers the value of the sum of assets a business has, as it operates as a going concern. This method can be applied to the book values used in case of business mergers or for companies under common control. However, a more fair approach is the fair market value of the assets used when a business acquisition (sale-purchase) occurs.

ii. Liquidation Value Method

If a distressed business or a business is about to go into bankruptcy or liquidation, it is a fair idea to evaluate its assets on its liquidation value. That is the value at which assets can be sold in a rush. So, the valuation under this method is relatively low than the value undervaluation as going concerned. 

iii. Breakup Value / Piecemeal Value

Under this method, the total value of a business is considered the individual costs of its parts. Therefore, each asset’s value is evaluated and added to aggregate the value of the company. This value usually presents a comparatively higher estimate than the liquidation value. 

iv. Capitalization of Earnings Method / Purchase of Profits

Another way to compute a business’s value is to divide a business’s profits by an average investment return. This is quite a crude, and simplified method to assess business value as fair return determination always becomes an arbitrary basis, causing debate on the validity.

2. Deterministic Models of Valuation

These models use assumptions and depend on different financial fundamentals, such as profitability indicators, cash flows, dividends, and the like. Some of the prominent methods under this category are:

i. Market Value-based valuation

In the case of acquiring a company, sometimes its shares are evaluated by its financial indicators. Then the acquirer makes a tender offer based on the valuation of company shares. This valuation is strictly based on the economic fundamentals and indicators like the P/E ratio, EBITDA, and other similar indicators.

ii. Relative Valuations (Comparables Method)

These are the valuations when there are similar companies’ data is used as a benchmark for valuation. There are two approaches in such models: the Comparable Transaction Model and Comparable Business Model / Multiples Methods (P/E, Franchise Ratio, etc.). The valuator seeks to find out a similar company or sale/purchase transaction, as is the deal under discussion, and apply the similar indicators for the ongoing strategic transaction to determine valuation.

iii. Dividends Discount Method (DDM)

In listed companies with stable profits and consistent dividend policy, this model presents a robust basis for determining business value. However, for it to be applicable, the profitability needs to be smoother, which sometimes is a challenge in this valuation.

iv. Discounted Cash Flow (DCF) Model

This is one of the most famous and comparatively robust bases for valuation than DDM. Unlike DDM, which uses dividends, DCF models use cash flows, which are more generalized and practical indicators than dividend growth, which sometimes presents inconsistency issues to compute reliable valuation.

3. Stochastic Models of Valuation

This is the most robust form of valuation models that assess a business’s valuation based on some dynamic basis, based on some complex mathematical or probabilistic formula or model. A specific categorization of these models is challenging to determine. However, the two prominent types of models can be specified as follows:

i. Probability Models

These models involve forecasting financials based on probabilities of occurrence and non-occurrence of events. In this way, these models compute the risk-adjusted scenarios of modeling. The use of possibilities gives a much stronger basis than assumptions, as is done in the deterministic models.

ii. Simulation Models

Rather than using probabilities or financial fundamentals, these models simulate an actual scenario and repeat the occurrences numerous times to see how a phenomenon moves under certain conditions. These models’ benefit is that these models experiment on authentic situations and present more clear results to reality than the conventional or deterministic models.

Conclusion

Valuations can be conducted through different approaches, of which we presented some main methods. The approaches get more robust and precise, more objective and fact-based, as we go from conventional to deterministic to stochastic models. Hence the stochastic models have the highest level of specialization and accuracy. In contrast, deterministic models are somewhat simplified and easy to use. Still, conventional models are used where (due to non-availability of relevant data or otherwise) deterministic or stochastic models are challenging to be used.

AM Auditing is the choice as specialized consultants in stochastic and deterministic valuations. AM Audit maintains competitive and comparative advantages over other firms doing conventional modeling-based valuations.

Should you hire a business valuation professional?

Are you planning to employ a business valuation professional?

As your company’s owner, you are likely to access all the raw data you need to analyze your company. Although this might be possible, you can only focus on your own observations for your own personal information. If you need a valuation for anything other than that, you should hire a specialist.

If you’re trying to sell a company, sell shares in a company, or have more partners, that’s where you’d like to have one specialist come in.

As for other small business considerations, you have to balance the risk against the value.

Although it could be worth it if you miss the expense and do it yourself, hiring an appraiser might be worth the cost in some instances.

A competent business appraiser can have reliable auditing capabilities and a comprehensive accounting report to ensure that the finances are correct. This removes questions as to whether or not you measured the value accurately when you did so yourself. In comparison, by selling your business, you benefit that the seller is attempting to bargain the price at a much cheaper amount because the business appraisal has been carried out by a specialist who can check its real value.

While their fees may be significant, having a company appraiser perform your valuation would give you the most reliable estimation of how much your company is worth. As in other business stuff, you’ve got to balance the loss against the value.

Looking for a Professional to Valuate your Business?

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