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An Overview of the Business Valuation Process
Victoria explains to Bob that a thorough business valuation is both a quantitative and a qualitative
process involving an analysis of many factors, such as risk and investment return. A valuation is more
than simply analyzing the firm‟s historical financial statements or its financial forecast. Valuations
that give the most reliable results analyze qualitative factors such as technology changes, competition,
and customers. In addition, other factors are also often analyzed, such as macroenvironment factors
like the firm‟s industry and the national and local economies. A business valuation will often include
the following areas:
• Analysis of the company.
• Industry analysis.
• Economic analysis.
• Analysis of the firm‟s financial statements.
• Application of valuation methods.
• Application of any needed valuation adjustments.
A large part of valuing a firm is analyzing the investment risk of buying and owning a business.
After the sale, the buyer bears the risk that the expected economic benefits may not materialize in the
future. Of course, there is no guarantee of actually receiving the forecasted earnings. A key concept in
finance is the relationship between risk and reward in making any investment. Rational people make
investment decisions by weighing the risk of an investment against the expected rewards. For instance,
a certificate of deposit from a bank that is guaranteed against default may have a rate of return
(interest) of 5%. This investment has virtually no risk. But over the long run, investments in large and
small public company stocks have historically earned an average of 10% to 12% and 15% to 20% per
year, respectively. These three types of investments illustrate the relationship between risk and reward.
Buying large company stocks instead of certificates of deposit carries more risk, and the market has
rewarded the investors with a higher return. Furthermore, small company stocks are usually more
risky than large company stocks, and they have historically rewarded investors with even higher
returns. This idea flows to business valuation. A large part of the analysis looks at the risk of an
investment in a firm and compares it to the risks of other types of investments. Next, the relative
rewards to an investor are considered.
Victoria further explains that valuation concepts are founded in several economic principles. The
first is the principle of alternatives, which states that each person has alternatives to completing a
particular transaction. In the preceding example, someone has options of investing funds in a bank
certificate of deposit, large company stocks, or small company stocks. Investing in a private firm is yet
another alternative.
The second economic principle in valuation is the principle of substitution. It states that the value of
something tends to be determined by the cost of acquiring an equally desirable substitute. For
instance, someone who is selling a home will likely set the asking price based on recent sales prices of
other houses in the neighborhood. If the asking price is significantly higher than prices of other houses
in the area, it is unlikely that anyone will buy that home. Rather, they would buy a home in the same
neighborhood for less money. Likewise, a potential buyer of a business is not likely to pay
significantly more than the price for a similar firm or other similar investment.
In business valuation, we must remember that buyers have other ways to invest their money, and
they will generally not pay significantly more for a business than the price of comparable investments.