Business assessment approaches, their advantages and disadvantages
Перепелица Д. Г., Ермольева Е. Д. Business assessment approaches, their advantages and disadvantages // Молодой ученый. 2016. №27. С. 476-479.
Nowadays business assessment is becoming increasingly important in making various decisions companies’ management. For any enterprise, it can become a subtle tool of planning and control of financial and economic activity. The use of assessment is able to increase resource efficiency and provide a higher level of security and control. But the main problem of business assessment is which method or approach of valuation to choose. Actually, people use different approaches of business assessment in different situations, in order to understand each type, its pluses and minuses, it is necessary to define term business valuation and clear out its peculiarities.
So, the purpose of this article is to point out and compare the main existing approaches of the valuation and present them a brief description, also to outline recommendations for the selection of a particular approach valuation.
According to the generally accepted definition, business valuation  is the establishment of an actual (i.e. market) value of a firm. That is the most probable price at which it can be sold in a competitive market. The business valuation can include determining the value of the local divisions of the company, fixed assets or equipment.
As a matter of fact, there are several situations when you need business valuation:
− — while doing transaction of purchase and sale of business or its part;
− — determining the value of collateral on the loan;
− — justification of investment decisions;
− — development business plan;
− — the justification of the tax base, etc.
Carrying out an assessment is not an easy deal, it requires several stages. Business valuation is made, according to the following algorithm:
− collecting information about the evaluation object;
− analysis and study of market niches in which it operates, the object of evaluation, search of similar companies;
− calculations on the basis of suitable approaches and methods of assessment;
− harmonization of the results obtained through the evaluation of different approaches and methods;
− preparation of the evaluation report.
In accordance with existing standards, to assess the value of any object property three approaches are used: income, market (comparative) and cost. Let us consider in more details each of them.
Income approach – is a set of object valuation methods based on the determination ofExpected Incomefrom the object of evaluationand itscomparisonwith current costs, taking into accountthe factors of time andrisk. Itinvolves the use ofcapitalisationanddiscounted cash flows method. The income approach is relevant, when it is possible to predict future income. It is based on determining the value of a business or its parts.
As a matter of fact, revenueis the foundationof establishingthe value of business.
Estimated revenueis calculated based onthe property complex of the business,general economicfactors(inflation, taxation, stability, etc.), industrydependency, presenceof seasonality, potential for development, receivedthe benefits, the risks associatedwith doing businessand earning income.
Income approach is divided into two methods: Capitalization method and Discounted cash flow method.
Capitalization method is based onthe efficiency calculation of an asset operationthrough the prism ofgetting income from them. It does not requirestudy and determinethe value of intangibleandtangible assets. Usually it is used, if the income is stableand positiveover time.
Discounted cash flow method is basedon forecasts offuture cash flows thatare adjusted tofair valueat a discount rate. It isuniversal, as itis appliedin conditions whenestimates of futurecash flowsdiffer from the current ones on more or less percentage.
The capitalization and Discount ratesare determined based onmarket information.
While using these methods, it is important to consider the following indicators: the level ofinterest rates (the refinancing rate andinterest rates ongovernment bonds), the yieldexpected by investorsfrom similar investments,and the riskinherent in the receipt of benefits and so on.
Actually, it can be said, that the income approachis most applicable, because itmost accuratelydeterminesthe value of the companyin the market, considering the businessas a commodity,which in the futureshould bringa profit to investors, also it has the following advantages:
− Takes into accountfuture changes inincome, expenses;
− Takes into account the level of risk(throughthe discount rate);
− Takes into account the interestsof the investor.
But, also has several disadvantages:
− The difficulty of forecastingfuture resultsand costs;
− There are several possible rates of return,which complicatesthe decision;
− Sometimes it is hard to take into account market conditions.
Another approach, which should be considered is a Comparative approach . It is a set of methods for assessing object value based on comparison of the object valuation with similar objects, in respect of which there is the information about prices of transactions with them. The comparative approach is based on the market information and considers the current actions of potential sellers and buyers. This method is based on the principle of substitution — a buyer will not buy a property if its value exceeds the cost of acquisition in the market for similar object that have the same utility. Sources of information used in this approach are the following: open stock markets, information-analytical agencies, previous transactions with the assets of the reporting business, the data of the official financial statements.
The comparative approach involves 3 evaluation methods:
− the method of branch coefficients;
− method of capital market;
− method transactions.
It is crucially important to clear out what each method means.
The method of branch coefficients is based on the use of pre-calculated and analyzed ratios between the sale price of the business and its financial performance. Usually this method is not used in Russia, because in most Russian companies there is no long cost monitoring of financial performance.
The method of capital market is based on the cost of similar companies whose shares available on the open market. Besides, this method guarantees the reliability and high speed rating.
While choosing similar company it is necessary to consider such criteria as roughly equal income, turnover, staff. Otherwise, it is advisable to use valuation multiples (price/cash flow, price/earnings, price/dividends, etc.) that reflect the relationship between stock price and financial base. Having a multiplier value for a similar company to realize value of shares of the company it’s enough to multiply the multiplier on the financial basis (cash flow, profit, dividend) valuation of the object.
The method of transactions is based on the price analysis of the control stock of similar companies. It’s used to assess the business as a whole or a controlling interest. Actually the above is correct, when the denominator multipliers are positive and there is a large amount of information for analysis.
The advantage of a comparative approach is that the price of business reflects the results of operations of the company, and the transaction price is the market situation.
Disadvantages of the comparative approach:
− does not take into account the value of the business in the future;
− difficulties with fitting similar businesses due to the weak development of the stock market.
Speaking about advantages and disadvantages of the comparative approach in general, they are the following:
− It is based on real market data;
− It reflects existing practice sales and purchases;
− Takes into account the impact of sectoral (regional) factors on the shares.
− Not clearly defines the organizational, technical, financial features of company organization;
− Only retrospective information is taken into account;
− Requires making many amendments in the analyzed information;
− Does not take into account future expectations of the investors.
The third method, which is going to be considered is Cost approach . Cost approach is a set of methods for assessing the value of business, based on the determination of expenses which are needed for restoration or replacement of the object, taking into account its amortization.
Cost approach is most applicable for companies of special purpose, material-intensive and asset-intensive industries, as well as for insurance purposes. Application of the cost approach to business valuation is necessary in two cases:
- first, the cost approach is indispensable for assessing companies, which are not in demand often registered in the form of LLC, CJSC, GUP-s, which tend to have opaque financial flows;
- second, the application of the cost approach with the income, allows you to make effective investment decisions.
Under the cost approach 2 methods are used:
− the method of net assets;
− liquidation value method.
The method of net assets is based on the calculation of the difference between market value of all assets and liabilities. It is useful, when it’s impossible with high degree of accuracy to predict the income from the business, but at the same time, the enterprise has a good financial and physical assets (e.g., investments in real estate, marketable securities).
Liquidation value method is mostly used when assessing the value of enterprise during bankruptcy, i.e. when it ends its existence, sells the assets at auction, begins to repay debt obligations.
Liquidation value is the difference between the value of the assets and costs of disposal.
In low timing of asset sales in the liquidation they may be sold at a lower price. That is why, this method gives the minimum result of the valuation of the business.
However, the pluses of using cost approach are mentioned below:
− Takes into account the impact of production and economic factors on the change in value of assets.
− Gives an estimate of the development level of the technology, taking into account the degree of wear out of assets.
− The calculations are based on financial and accounting documents, i.e. the evaluation results more credible.
As for disadvantages, they are the following:
− Reflects the last value.
− Does not take into account the market situation at the valuation date.
− Does not take into account the prospects of development of the enterprise.
− Does not account for risks.
− Has no connection with the present and future results of operations of enterprise.
Moreover, it is important to mention, that considering modern market trends, approaches, which used by management, an assessment made on its own, by the company, will not be considered as official in the court or other conflict situations. In order to make it more official, it’s necessary to apply for help to independent expert, assessment company.
In conclusion, it can be said, that considering business valuation approaches and their advantages and disadvantages, it is difficult to say which approach is the best. None of them can be used as the base. In practice of companies’ assessment there are various situations. For each class of situations different approaches and methods are appropriate. In order to understand which approach to use, you must first classify the situation using object grouping, type of transaction, the moment at which to assess, etc. If on the market there are dozens or hundreds of similar objects, it is advisable to use a comparative approach. For the evaluation of complex and unique projects, cost approach is the most preferable.
In a perfect market all three approaches should lead to the same value. However, most markets are imperfect, the potential users can be misinformed, manufacturers may be ineffective. These approaches can give different indicators of value. So, that is why, we cannot say definitely, which approach and which method to use. A company, which carries out the valuation, should decide it on its own, by assessing the situation.
- Investopedia, article «Business valuation», http://www.investopedia.com/terms/b/business-valuation.asp
- Investopedia, article «Income approach», http://www.investopedia.com/terms/i/income-approach.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186
- Article «Comparative approach: theory and method», https://us.sagepub.com/sites/default/files/upm-binaries/9869_039458Ch02.pdf
- Investment dictionary, article «Cost approach».
- Analytical Portal – «Utmagazine», article «Методыоценкибизнеса» http://utmagazine.ru/posts/8819-metody-ocenki-biznesa.