The Future of Business Valuation
In this age of digitalization nothing can be measured or evaluated the way it used to be. This applies to absolutely everything, without any exception, at all levels and aspects of human life and activity.
Business valuation, being an important integral part of finance industry, is one of the many areas that must consider technological improvements when making decisions about the right choice of valuation methods and approaches for each business. As we know, discounted cash flow (DCF) valuation is one of the most commonly used traditional methods for decades. However, nowadays it tends to become obsolete due to business complexity and globalization. Sometimes this method is prone to error and very sensitive to assumptions that can lead to a misperception of the true "value" of the business. There may also be challenges in calculating the weighted average cost of capital (WACC) and terminal value for some businesses. So, along with the traditional methods, it is necessary to follow the current trends.
Trends in business valuation
- AI and machine learning algorithms – There is a growing use of these algorithms in business valuation which are especially useful when dealing with complex data. AI helps to improve accuracy and increase efficiency by reducing the risk of human errors and the time needed to complete a valuation. As a result, there can be automated valuation reports in real time that are easily adapted to changing market conditions.
- ESG factors – Investors are now much more attracted to businesses and organizations that invest in ESG. While the evaluation of these factors is critical, consensus on a standardized approach to integrating ESG into evaluation is first needed. The International Valuation Standards Council (IVSC) released a paper “ESG and Business Valuation” to foster the importance of incorporating ESG factors in business valuation process. According to that paper there is a misconception that as ESG disclosures are mostly non-financial in nature, they are not financially relevant. If this is the case, it means that ESG factors are not considered as one of the factors to evaluate the long-term stability of the company, which is not true at all.
- Intangible asset valuation – Intangible assets (intellectual property, goodwill, customer loyalty, brand recognition) are now more important to business growth than ever before. There are 5 methods for intangible asset valuation:
- Relief from royalty method (RRM) – The value is determined using the estimated savings in royalties that would result from owning the asset as opposed to licensing it. This method is often used to value trademarks and computer software, including assumptions from both market (royalty rate) and income (revenue, tax rate, discount rate, growth rate) approaches.
- With and without method (WWM) – This method is used when there is a need to value intangible assets by comparing two discounted cash flow models, one that includes the asset and the other that does not. WWM is common for valuing non-compete agreements.
- Multiperiod excess earning method (MPEEM) – This method relates to discounted cash flow analysis. By isolating the cash flows that may be associated with a single intangible asset and discounting them to present value, MPEEM calculates fair value without focusing on the entire entity. MPEEM is typically used when a single asset is the company's main source of value, so the cash flows associated with it can be separated from the company's total cash flows. An example of such asset for this method can be computer software or customer relationship.
- Real option pricing – “The most difficult intangible assets to value are those that have the potential to create cash flows in the future but do not right now.”,- Aswath Damodaran. This one sentence clearly explains the idea behind this method. An example of such an asset would be undeveloped patents.
- Replacement Cost Method Less Obsolescence – As the name suggests, this method is based on determining the replacement value of an intangible asset and then adjusting it for obsolescence, such as depreciation, which is used under the cost approach.
After understanding the concept of each of these models, it is obvious that the valuation of intangible assets is more complicated than tangible assets. A variety of data sources and techniques should be used to achieve more accurate results in the intangible asset valuation process.
Thus, the future of business valuation is evolving dynamically. By using AI technologies and emphasizing the importance of ESG integration and intangible asset valuation, more accurate and efficient business valuation results are expected. However, these are just a few trends. If you want to explore more, contact us and our experts will help you find the best valuation solution for your business.
Prepared by: Seda Janazyan, Business Analyst at CFOnline.co
