Entrepreneurship and Small Business Development Outline - Private Company Valuation - Essay Example

?Running head: Private company valuation Entrepreneurship and Small Business Development Insert Insert Insert 10 January 2011 Outline Introduction Valuation of private companies Various techniques used in valuing private companies Advantages of the various techniques of valuing private companies Disadvantages of the various techniques used to value private companies Other alternative methods that can be used to value private companies Conclusion Entrepreneurship and Small Business Development Introduction Entrepreneurship has long been valued as an essential feature in the market-based economies. Additionally, when medium and small enterprises grow, the market-based economies greatly experience a boost. Entrepreneurship entails the process by which one recognizes an opportunity, and utilizes it to become successful without really putting into consideration the current controlled resources that he/she has. It entails changing ones course towards new things that are considered more creative in generating ones desires. Growth of medium and small businesses encompasses an increment from a low level of business to an advanced level, covering operations over a large scope. There is a wide variety of business forms depending on their size, management, as well as proprietorship; and ranging from public corporations, private companies to the smallest businesses that are singly owned. The operations of each form of a corporation may take several courses where some come together to operate as a group, while others remain singly operated (Smallbone, 2008). For successful enterprises operations, valuers and policy makers or even the proprietors always find it necessary to value companies according to the prevailing operations. Valuation is crucial for it assists the concerned parties in making appropriate decisions as well as laying the corporations on a scale, a factor that helps predict the future direction of the companies. More so, different techniques and approaches are employed in the companies’ valuations, which are carried out depending on the form of the company at hand. Private company valuations are thus deemed very important in the day-to-day running of the corporations. There is a need for employment of different techniques in the valuation processes to enhance a comprehensive cover, since each technique yields distinct Results. This paper is aimed at investigating into the valuation of private companies and several valuation techniques in details. Additionally, it will be crucial to establish the advantages and disadvantages of the several methods herein discussed as well as the other alternative methods that could as well be used in the valuation processes in regard to private companies (Bridge, et al., 2003). Valuation of private companies Company valuation is a process that entails the utilization of a sequence of procedures in estimating its value. This process is mainly carried out by valuators, who come up with a comprehensive report concerning the company’s assets and liabilities. Financial participants in the market mainly use the valuation as a basis for price discussions when the company is on sale. Earlier research has not established a professional method or approach that provides an actual value of a particular company, but numerous approaches and techniques are considered important in determining the value of a company. The current available used techniques only provide an estimate of what the company is worth. Various factors are always considered when valuing a company depending on whether the company is privately owned or publicly owned. Valuation processes are carried out with a lot of caution, considering the company’s assets quality, the nature of its liabilities as well as the intangible assets. It is beneficial to value a company’s assets since it helps the investors in making sound decisions concerning their company. Additionally, it is often important in giving prospective buyers some confidence due to the full awareness of the company, value. It is as well crucial to the management of a private company, since it increases their awareness on their current position. This awareness is used in coming up with a strategic plan which would be geared towards improving performance and productivity of a particular company (Landstrom, 2009). When valuing a private company, the process depends on the information that the company’s proprietors supply to the valuers. Compliance mandates do not bind this information at all as it happens with public corporations, but it is always considered essential for the information to recorded and documented for future reference. There are several major reasons of valuing a private company, but some are more important. For instance, when the company is in need to secure a debt from a financier, finance verification would be obtained to prove it a liable candidate for the process. Furthermore, the value of a company is necessary during its sale or purchase by the potential buyers and sellers. Most important, the process of a private company valuation entails both the tangible and intangible assets. The following are several techniques, which are majorly employed in the process of the private company valuations (Pratt, 2000). Various techniques used in valuing private companies The market capitalisation approach (using P/E ratios) This method of private company’s valuation is based on the value of the company’s stocks, whose theoretical values are often calculated. The method is usually very essential in predicting the future prices of the company’s target markets. It mainly is aimed at providing intrinsic values estimations of the market capital (Ndirpaya, 2010). The technique utilizes the price to earnings ratio, mainly based on statistics and historic ratios .The main aim is to provide an assignment of value to a company considering its stock as well as taking into consideration other attributes that can easily be measured. Additionally, the use of ratios to value a company gives a comparison of the market value of a company to the company’s performance aspect. The following formula is often utilized to come up with the correct price to earnings ratio figures. Price to earnings ratio On performing the above calculation for a particular company, the type of value that is obtained has some significance. The implications of a higher price- earnings ratio is a clear indication that the company’s investor are supposed to expect a higher a growth as a result of higher earnings in future contrary to lower values of price to earnings ratios. The technique also gives room for comparison of price to earnings ration of one company with the others that have the same industrial set up as the company at hand. In addition, the investors can utilize the method to form the basis for their investments. The ratio serves also as an important tool to compare the growth prospects of different companies (Pratt, 2000). Discounted cash-flow models DCF is among the most commonly utilized techniques in the valuation of private companies. It is an important approach that provides the estimates of a company’s value, since it has not proved to give an actual value according to early research reports. This method investigates into opportunities of investment that are available to a company and digs into understanding how attractive the opportunity at hand would be. The analysis carried out using the DCF approach utilizes the projections of upcoming complimentary cash flows. The then upcoming cash flows are discounted by the utilization of averaged capital cost that is weighted, leading on the establishment of a company’s present value. The present value of a company helps in evaluating an investment opportunity in the prevailing market. A higher DCF analysis value indicates a good opportunity for a company to utilize and move forward, while a lower value indicates a poor opportunity that would be too demanding to the company in case of its utilization. Various tools can be used for calculating discounted cash flows and thus many variations are encountered in these processes. The models used in this approach are very powerful incorporating complex calculations. However, the main objective of utilizing the discounted cash flow models is to provide an estimation of the money that would be obtained from a particular investment. This would help the company to adjust in accordance, to either improve higher or lower results depending on the available results (Kumar, 2008) Net asset valuations Net asset techniques as used in the private company valuation is among the asset approaches, which mainly depend upon the company property. Assets are grouped into tangible and intangible assets. Similarly, the value of liabilities in a particular company is crucial in this case. Net asset value is usually calculated as a sum-total of company’s assets- liabilities. This is the most commonly utilized technique in large and small corporations since they just need to use the recorded books consisting of the company’s assets. Mainly, the approach considers the accounts information recorded in the balance sheets of the company, and no adjustments are made in the sheets. Thus, the difference between the total assets and total liabilities gives the value of the company being valued. The method assumes that the value of the company at hand is based on nothing else but the assets and discarding the fact that the management and other factors would be important in determining the value of the company (Pratt, 2000). Advantages of the various techniques of valuing private companies The valuation of a company is very essential, encompassing a great variety of merits. First, the valuation process results in establishing the value of a particular company, or rather what a company is worth. The various numerous methods employed give e ach distinct results, depending on the tools utilized in each of the methods. Researchers have also come up with a variety of these techniques with an aim of introducing the best that would be able to provide comprehensive information on a company’s value while considering all aspects. First, the value of a particular company is the basis of its buying and selling price. Most companies require their value mainly when they are being sold to potential buyers, since the determined values usually form the basis of the buying and selling price discussions, hence the company’s value can not be underestimated. This is a factor that also contributes to the confidence of the prospective buyers, knowing that they have every surety of the products that they are ready to buy (Smallbone, 2008). Secondly, the valuation of a company determines the future direction. For instance, the utilization of the discounted cash flow method entails the investigation into the opportunities that a company would have in the prevailing market. By the calculation of the discounted cash flow methods, the company’s management will be able to identify the available opportunities and utilize them strategically to increase their value. It is possible to plan strategically to achieve their already set goals. More over, the value is crucial when a company is in need of financial support by a debtor. The debtor would have confidence-lending money to a company that has its correct value since they have confidence of what the value would raise in the case of repayment failures. Furthermore, the net assets method helps in record keeping. Owing to the fact that the value of the net assets and liabilities would be needed to determine the value of a company, the management is always alert to keep appropriate records, lest there occur an over or underestimation in its value during the evaluation (The ABA Journal, 1983). Thirdly, understanding the value of a company assists the management in making sound and helpful decisions. Depending on the values obtained from the market capitalization approach, they are able to assess what ways to follow to maintain high price earnings ratios and what to do incase they are lower than expected to raise them. Also, appropriate company variations create room for increased growth. By calculating the value, the company is able to target the right market for its operations in order to enhance sustainability. Furthermore, the values enable the strategic planning processes as well as strategic change management for better growth. Therefore, it is advantageous to use the various techniques in the private company valuation processes (Charantimath, 2007). Disadvantages of the various techniques used to value private companies Several limitations are anticipated when utilizing the above and other techniques in private company’s valuation processes. First, all the above techniques are time consuming, since a group of individuals who are experienced have to take their time drawing the company’s operations, which is the key element in determining the value. Additionally, the processes drain the company’s resources since the personnel involved are highly skilled, whose payments must be handsome enough to build up their morale to perform the challenging tasks. More over, since no approach so far is known to provide accurate results and all just give rough estimates, it becomes cumbersome to determine whether a great variation has occurred between the obtained and the actual value, and no method can be proved a standard one for use by all companies to determine their value. Furthermore, apart from giving the figures, the process may deem useless to some companies, who even if discover their value, are not strategically placed to improve their productivity. Thus, the values obtained may become a source of discouragement to the management of these companies, and other companies on discovering the value of others may become a threat to them in the market. The value also requires a high level of confidentiality, only accessible by the financial officers in a company, and failure to that, the private companies may be prone to the risk of competition. The herein discussed techniques have proved to have some characteristically pronounced limitations (Charantimath, 2007). To start with, the market capitalisation approach (using P/E ratios) has several anticipated limitations that deem it not very useful as a company valuation method. The method is not reliable for the earnings value can be easily exposed to some form of mechanical manipulation by the involved parties due to the fact that it is dependent on an accounting measure. Thus, this results to the value of the price-earnings ratio alike with the number considered as the earnings number. Considering the use of ratios, it requires a lot of context in order that the valuator understands exactly what is needed in the process, thus increasing the complexity of the process. At the same time, it may not be easy to obtain the values, especially where accurate records are not often stored. The calculations are time consuming during their operations, which may not impress most investors. More over, the method mainly basis its calculations on the company’s stock values, putting aside other factors that may as well be essential to consider in the valuation processes (Smallbone, 2008). Additionally, the use of discounted cash flow methods has several shortcomings, which are deemed as factors to its disqualification as a best approach to determining the value of a private company. Fist, it is a complicated method involving complex calculations. Hence, it is a tiresome and time-consuming method for use in the process of private company valuation. At the same time, depending on the tools utilized by the valuers, it provides variations. Thus, it cannot be termed as a standard method that each valuator can use, since different valuers using the same method can get different results while still using the same method but different tools. On the other hand, discounted cash flow variation is a tool that does operate mechanically, whose implication is that of garbage in, garbage in, garbage out. Thus, it is anticipated to give wrong company values thus calling for the utilization of very complex tools. Under normal circumstances, discounted cash flows do yield extremely large figures for small changes in the company’s inputs, sometimes producing unexpected results. Due to the complexity in calculations, the approach requires a valuation conducted for a period of over ten years, which means this method cannot be used for valuing as time goes on; hence, a certain period has to elapse before the method becomes useful to valuers (Charantimath, 2007). Furthermore, the use of Net asset valuations technique had definitely pronounced shortcomings that may render it not very useful as a method of company valuation. It assumes that the value of a company can only be determined by the value of assets alone, forgetting that also the other aspects are very essential. Secondly, the operation performed by the company at the very moment of the operation are not put into consideration, an indication that the company does not seem like a continuing business, thus, obsolete results are obtained from the method. More over, the data is exposed to a lot of inaccurateness, for the method does not put into consideration the other factors like the managerial knowledge, the technological status of the company as well as other crucial factors that should be included in the company’s value (Bridge, et al., 2003). Other alternative methods that can be used to value private companies Comparable company analysis This approach is often termed as an investment banker’s method. It has long been considered as one way of determining the true value of a particular company. This method includes the use of an analysis of different companies; hence, the results obtained provide appropriate estimates, i.e., both the value of the actual market as well as the intrinsic values of the private company. Companies with similar structures or characteristics are usually considered to have identical multiple valuations. This method evaluates companies with similar industrial set up, net incomes, market sizes as well as revenues that they generate. The valuers that employ this method often have to be very committed to carry out research from the various companies that have to be compared (The ABA Journal, 1983). In real sense, a valuator has to identify a group of companies that have similar characteristics and come up with a fine list. The valuation process is carried out by applying valuation multiples that are comparable with one another in order to come up with valuation that is relative. There are some common multiples of valuation that may include enterprise ratios to EBITDA ratios, price to earnings ratio, or even the price to book ratios. These comparisons of multiples yield a value range that is relative which can be used as a measure of a company’s value. This method is often viewed as one of the best metrics of valuation since it employs the use of the current company’s stock price. The method is also essential in valuation of potential IPO’S, considering the fact that the procedures are based on the prices of the company’s stocks. Nevertheless, the technique is anticipated to have some major drawbacks in that it is not always easy to find companies that posse’s similar characteristic, which are likely to be compared. Additionally, less reliable metrics can be obtained when comparing multiples based on medium and small enterprises, especially those comparatively liquid in civic markets. Furthermore, the method is used only in valuation of non-controlling minority multiples in a company that are deemed less important in acquiring valuations (The ABA Journal, 1983). Capital Asset Pricing Model This method helps to establish the correct rates of discounts in the valuation of businesses. It entails the summing up of the risk free rate to risk free premium. It helps to establish the volatility of stock price measure, Beta value, mainly associated with investments’ risks that are deemed systematic. The method is often considered as an appropriate one for the valuation of private companies, rather than the public ones (The ABA Journal, 1983). Conclusion Valuation of companies is a very important role that is performed by valuators. Generally, the valuation processes help define the company’s past, future as well as the determination of the present status. The aim of the paper has been achieved in that the advantages and shortcomings of valuing private companies have been established. Additionally, it has been possible to come up with the various techniques and approaches that are used in valuing the companies. Other alternative methods are also found to provide the value of the companies; however, of all methods that have been used or researched on, none has proved to give precise results on the value of private companies, rather, they give estimations. Finally, it is possible to value a company, a process that keeps the company’s management informed as well as enabling performance with an aim of increasing productivity (Skarda, 2010). References Bridge, S. et al. (2003). Understanding enterprise, entrepreneurship, and small business. London: Palgrave Macmillan books. Charantimath. (2007). Entrepreneurship Development and Small Business Enterprise. New Delhi: Pearson Education India. Ndirpaya, B. et al. (2010). Prospects and Challenges of Engineering Valuation Practice in Nigeria. Retrieved from http://www.iacenig.org/2010%20IACE%20Conference%20Presentation/Prospects%20&%20Challenges%20of%20Engineering%20Valuation,%20by%20Engr%20Battah.pdf Kumar, A. (2008). Small Business and Entrepreneurship. New Delhi: I. K. International Pvt Ltd Books. Landstrom, H. (2009). Pioneers in Entrepreneurship and Small Business Research: Volume 8 of International Studies in Entrepreneurship. NY: Springer Books. Pratt, S. (2000). The lawyer's business valuation handbook: understanding financial statements, appraisal reports, and expert testimony. NY: American Bar Association. Skarda, K. (2010). Public vs. Private Company Valuations: What’s the Difference? Allied Business Group, Inc. Retrieved from http://www.alliedbizgroup.com/docs/PublicvsPrivateCompanyValuations.pdf. Smallbone, D. and Welter, F. (2008). Entrepreneurship and small business development in post-socialist economies. Volume 14 of Routledge studies in small business. NY: Routledge books. The ABA Journal, Vol. 69. (1983). NY: American Bar Association. Retrieved from http://books.google.co.ke/books?id=fc0ZSsM6_0cC&pg=PA1244&dq=The+market+capitalisation+approach&hl=en&ei=uMwsTd2wGo2zhAeg0_HsCA&sa=X&oi=book_result&ct=book-preview-link&resnum=4&ved=0CDcQuwUwAw#v=onepage&q&f=false. Read More