Three most common small business valuation model categories continued

There is a saying that goes something along the lines of “important things should be repeated, important things should be repeated”, which is why we need to mention the significance of valuating your business again. If you are looking to sell, or bring in more equity, the need for valuation is obvious. But valuation is also a powerful tool when managing your business. Your strategic decisions are more easily tracked in value, and not just in money. Furthermore, it gives you a holistic view over your company, and helps you foresee the consequences of your actions.

Back on track

Now that we have that covered, we can return to the different methods of valuating a business. It can be difficult keeping track of the different limitations and benefits associated with them. In the previous post we discussed two of the models: accounting based valuation and relative valuation models. In this post, we are going to look at the last of the three most common business valuation model categories, which model we like the most and of course – why.

Accounting-based valuation models

Valuation models that are based on accounting usually originate from cash flow models. They’re reworked and adapted so that it is possible to use accounting information directly in the model. So accounting models are based on the book value of assets and liabilities. They are also based on historical cost (or whatever valuation principle is used in the financial statements), which ignores opportunity costs and replacement costs as well as the time value of money. The models rely on the clean surplus relation, i.e. that changes in the equity of the company can solely be explained by net income and the transactions with the shareholders. The true benefit of these models is that they use the balance between the three financial statements; income statement, balance sheet and cash flow statement, to indirectly derive cash flows while having income and balance sheet data directly as inputs to the valuation.

Residual income valuation model – accounting and valuation in a golden mix

This may not be the most well-known valuation model, but it is widely used by analysts. Let us tell you why. The residual income model discounts future excess returns based on available accounting data. Now, residual income is more than excess cash, it is the income that is left after having accounted for the true cost of capital. The income statement includes one’s cost of debt, but usually ignores other equity costs. The residual income model basically looks at the cost of equity as the stakeholder’s opportunity cost, giving a more accurate value to the business.

Compared to many other models, the residual income valuation holds one distinct advantage. It is based on the comparative stability of accounting measures, while the commonly used free cash flow model is based on volatile cash flows. Cash flow figures are considered more uncertain to base future forecasts on, as the numbers tend to vary a lot over time. On the other hand, this is where you have to be a little careful. Since there is potentially a bit of management discretion in accounting numbers, making your forecasts must be done after an analysis of the quality of the accounting data at hand. That being said, the residual income model is growing in popularity as it can give you a pretty clear look at what the actual intrinsic value of your business may be.

Wrapping it up

It might feel overwhelming when you start to research business valuation, and you realize there are numerous models out there. The tools and methods can vary amongst industries and valuators. The most important thing to keep in mind is to look at each company individually. Based on their characteristics, different valuation methods will apply. Decades of experience have shown us what works in different situations, even though the residual income valuation model ranks highly due to its simplicity and intuition. We hope that this mini-series has showed you the same!