How to Evaluate a Company: Fundamental Considerations

A business valuation is a complex process with several fundamental elements to consider in determining the right market price.

To achieve their goals, entrepreneurs need to make strategic decisions about their business. These decisions often involve determining the organization's fair market value. To do this, it is necessary to:

• determine the appropriate valuation report;
• select a valuation approach and method;
• take the entity's risk factors into consideration.

Determining the appropriate valuation report

The fair value of a business is determined by professionals known as Chartered Business Valuators, or CBVs. The value conclusions provided by a CBV are established in three different types of reports, depending on the level of assurance the client wants. The types of reports are as follows.

Calculation valuation report

A calculation valuation report contains a conclusion as to the value of shares, assets or an interest in a business that is based on minimal review and analysis of the information received. This type of report can be based on several assumptions provided by your organization's management. It is the least expensive and detailed of the reports. It also offers the lowest form of assurance regarding the value conclusion. This is the type of report most often used by clients for tax planning purposes or for smaller transactions.

Valuation report on an estimate of value

A valuation report on an estimate of value contains a fair value conclusion based on a more in-depth analysis and corroboration of the information received than the calculation report. This report contains more detailed information about your business such as an analysis of its historical results, a description of its customers, suppliers, human resources, competitors, and a summary review of the industry and economic context. Because of the greater depth of analysis and corroboration, this report offers a higher level of assurance than the calculation report.

Comprehensive valuation report

A comprehensive valuation report contains a fair value conclusion based on an extensive or comprehensive review and analysis of the business, its industry and all other important components to determine its value. This information is substantiated appropriately and is set out in a very detailed valuation report. This type of report is often produced in the context of litigation or more complex and significant transactions. It provides the highest level of assurance of the report types.

Selecting a valuation approach and method

Considerable information needs to be obtained and analyzed to produce a comprehensive valuation report. Among others, the valuator needs to:

• Obtain sufficient knowledge of the business's operations and inherent risk factors;
• Obtain detailed financial information;
• Analyze the balance sheet and capital structure;
• Analyze historical results and make adjustments to reflect any item that is not representative of the entity's future earnings;
• Analyze the business's financial forecasts.

The valuation approach and techniques will be determined depending on the type of business and the information obtained and analyzed.

Asset-based approach

The asset-based approach is generally employed in the following circumstances:

• Potential buyers would mainly be interested in tangible assets because of the company's makeup (a real-estate company or a holding company, for example);
• The company is planning on liquidating its assets because it is no longer viable as a going concern or its profits do not provide a sufficient return on investment.

Income-based approach

The income-based approach is generally used when:

• The company is realizing sufficient return on investment;
• A potential buyer would be interested in projected future profits and cash flow.

The income-based approach assumes that the organization will continue to operate and report profits and increase either profitability or cash flow over time.

There are several recognized methods for determining the value of your business based on such an approach, including the capitalization of earnings method, capitalization of cash flows method, discounted cash flow method, and variations such as the capitalization of earnings before interest, taxes, depreciation and amortization method (EBITDA).

Market-based approach

In addition to the valuation approaches and methods presented above, determining the fair market value of a company involves a review of comparable transactions and an analysis of companies in the industry. This approach provides various financial ratios that can be applied to your business. These ratios should be applied carefully as comparable organizations may differ considerably when it comes to company size, their target market, product range, financial capabilities and growth potential, etc.

Taking the entity's risk factors into consideration

Critical to determining the fair market value of your business is the identification of various risk factors. These risks have a direct impact on the business's value, either upwards or downwards. Here are a few examples of various external and internal risks:

External factors

• The economy;
• Financial markets;
• Regulations;
• Competitors;
• Customers;
• New technologies;
• Availability of resources;
• Etc.

Internal factors

• Workforce qualifications;
• Management team's experience;
• Presence of successors within the organization;
• Level of recurring revenues;
• Level of dependence on certain customers;
• Financial situation;
• Sales staff's performance;
• Installations' quality;
• Products and services life cycle;
• Etc.

As mentioned, valuing your business is a complex exercise where a wide range of variables must be taken into consideration and, above all, appropriately addressed.

Don't hesitate to ask for help from a business valuation expert who will guide you through the process and help you make informed decisions.