Different Ways Of Valuing A Business

Different Ways Of Valuing A Business

There are two ways to value a business:

1)Value the firm as a going concern and then discount the growth in cash flows with a risk-adjusted rate.

2)Run the company for a few years and then liquidate the company after the period. The value of the business is the sum of the discounted cash flows during the operating period, and the liquidation proceeds to the risk-adjusted rate.

As many startups and distressed companies shut down due to the lack of access to capital or high leverage, valuing such companies by DCF will overvalue them as DCF assumes that companies will be a going concern. Therefore, we need to incorporate a failure rate for distressed companies and a survival risk for young companies in these instances. The failure rate for a company that has issued public bonds will be its default risk. The interest coverage ratio is a better indicator for companies with no traded bonds.

For survival risk, the best metric is the current cash holdings position. The survival risk is higher for companies with low/no cash positions than for firms with solid cash holdings. In a weak economy, companies with low cash positions do not survive as raising capital becomes difficult in a slowdown.