We have considered the notions of value and worth as a somewhat philosophical level. We now turn to our central topic, Business Valuation.

We have defined Business Valuation as follows:

Business Valuation is the process of determining the economic worth of a company or a specific part of a company through the assessment of the financial and non-financial factors that contribute to (or detract from) the value of the business.

We will see that various methods are employed in business valuation, and while the specifics of these methods may differ, they all share some guiding principles. The two fundamental principles that underlie all business valuation methods are the concept of fair market value and the importance of future cash flows.

Fair Market Value

Fair market value is a central concept in business valuation. It represents the hypothetical price at which a business or asset would change hands between a willing buyer and a willing seller in an arm’s length transaction under normal market conditions, each party being adequately informed.

We can derive several important points related to fair market value from this definition:

• Market-Based Pricing: Fair market value assumes that the transaction would occur in an open market where buyers and sellers have access to all relevant information (i.e., being adequately informed). It should reflect current market conditions and not be influenced by any specific buyer or seller. We could go as far as requiring the transaction to take place on the ‘primary market’ for that type of transaction, e.g., when transacting listed company shares, the appropriate market is the stock exchange. Specifically, we are not limiting the scope of the market in which the transaction takes place to be sub-optimal or in some way closed from market participants.
• Willing Participants: We need the buyer and the seller to be under no compunction to – or not to – consummate the transaction.
• Objective and Unbiased: Fair market value should be determined objectively and without bias. Valuation professionals should apply standardised methodologies – to the extent possible – and avoid solely subjective opinions or external pressures (e.g., from parties involved in a transaction).
• Legal and Regulatory Compliance: Fair market value accounting standards, such as the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), require businesses to report their financial statements at fair value for certain assets and liabilities.

The Importance of Future Cash Flows

A person buying a business is buying a right to the future cash flows generated by the business. What the business has done in the past is not a determinant of its current value. This can be a hard concept for business owners to take on board.

Since we are dealing with future cash flows, we also need to appreciate the concept of the time value of money. We will pick this up below.

Key points related to the importance of future cash flows we need to keep in mind are:

• Discounting: The estimated future cash flows need to be represented in terms of their current value. Using the concepts from the time value of money, we need to discount these future values to their present value. The discount rate we use will be specific to the situation. The value of the business is the net present value of those future cash flows.
• Income and Cash Flow Projections: Estimating the future is an inexact science. Our projections need to be grounded in reality to be meaningful. We generally consider the future to be some extrapolation of the firm’s past performance, overlaid with market and industry trends, macroeconomic conditions, and a range of other relevant information. The use of the historical financial performance data is what generally confuses people as to how businesses are valued. Even valuation techniques that solely use historical data do so in a way that incorporates the prediction of future performance.
• Risk Assessment: The reliability and predictability of the projected future cash flows are crucial. The risk of attaining (or not attaining) these projections is central to the risk assessment – which also drives the discount rate. Businesses with stable and growing cash flows are generally considered more valuable than those with uncertain or declining cash flows. Risk factors, such as market conditions and competition, are taken into account when estimating cash flows.
• Terminal Value: In many valuation models, a terminal value is calculated to account for cash flows beyond the projection period. This terminal value often represents a perpetuity or a long-term growth rate and is a significant component of a business’s present value.

The different valuation methods we will use rely on these guiding principles in determining the value of a business.

The valuation methods actually selected will depend on factors like the nature of the business, the availability of data, and the specific circumstances of the business valuation.

The Time Value of Money

The concept of the time value of money (sometimes referred to as TVM) is a fundamental financial principle that needs to be properly understood to effectively appreciate business valuation. The time value of money reflects the idea that the value of money changes over time: a dollar received today is worth more than a dollar received in the future. Why? Because money has the potential to earn interest or generate returns, so the sooner you have it, the more you can grow it. Conversely, money received in the future is subject to the risk of not realizing those potential returns.

Present and Future Value

In considering the time value of money, we have two points of value, now, and some point in the future. We refer to these as the present value (PV) and future value (FV).

Present value recognises a future sum of money is worth less today than its face value. To calculate the present value of a future amount, you discount it at a specific rate to determine its current worth. The discount rate is also referred to as the required rate of return.

Future value represents the worth of a current sum of money at a future point in time, taking into account the interest or return it could earn over that time period.

The time value of money is a crucial concept in finance, and has applications well beyond business valuation. It helps businesses assess the potential profitability of investment decisions and evaluate the attractiveness of financing options, taking into account the opportunity cost of capital and the risk associated with future cash flows.

Conclusion

Fair market value, future cash flows, and the time value of money are cornerstone concepts in business valuation practices, helping stakeholders make informed decisions about buying, selling, investing, or financing a business. In later articles, I will drill down into the nuts and bolts of business valuation using these concepts.