Valuation Overview: An Art and a Science

Value at the simplest level is the monetary worth of a good or service or business (‘asset’) owned by a party or person.  It is a measure of the benefit provided by a good or service.  It is expected that in an exchange between informed and interested sellers and buyers (‘parties’), this worth should be realised by the owner of that asset.  Other factors come into play including emotions, motives, expectations, specific requirements of the parties, market expectations, trends, and the economic environment.  So arises the oft quoted idiom ‘price is what you pay; value is what you get’.

Valuation of an asset on a date involves an assessment of expected future benefits and, applying the returns in compensation for the risks assumed by the providers of finance, to convert such expected future benefits into a range of values on the specified date.  This involves forming a view on the expected benefits and the conversion process.  It requires judgment, which is often a blend of art and science.

Valuations are required for several purposes: sale and purchase of an asset; reporting to investors or lenders; and attracting new customers.  The purpose for which the valuation is being undertaken and the party for which the valuation is being undertaken has a bearing on the standard of value, and the valuation method used.

Status of the business or asset  

A business is effectively a portfolio of capabilities and competencies.  These include customer connections and contracts, supply and distribution channels, cash flows, capacity to deliver, people who can deliver, and often a clear competitive position.  Developing these requires time, energy, and commitment.  

The business development journey involves:

• formulating an idea
• testing its commercial and market appeal
• establishing customer relationships and contracts
• obtaining capital to achieve these
• planning and executing on these 

Some treat only formulating an idea as developing a business.  They are clearly different stages.  It is necessary to align the valuation method with the stage of business development.  

Pre-revenue and early-stage businesses tend to be valued using qualitative measures and scorecards as they do not have established or evidenced earnings or profitability performance.  Later stage and established businesses are normally valued using the methods discussed below.

Risks and returns  

Investors expect returns to compensate for the risks they assume when they invest in a business and the opportunity foregone for investing in a comparable opportunity.  

The risks at each stage of the business development journey are different.  In the early stage, the risks reflect the uncertainties associated with the mortality and success of the business, the amount of investors’ time required to develop the business, and the level of confidence in projected benefits (in the absence of evidenced performance).  In early-stage businesses investors also focus on what they can realise when they exit their investment.

As a business develops, its risks tend to converge to the risks associated with an established business relative to the market in which it operates.

Expected or required returns typically represent a combination of a risk-free rate, such as a government security, and a risk premium which reflects the risks associated with the business being valued.  They also reflect the expectations of the finance providers.  This is the return that a business would have to generate for its investors (both debt and equity) and is therefore the cost of finance for the business.  Such costs are used to discount or capitalise future benefits. 

Timing of expected investments and benefits

As future benefits are used in assessing value it becomes necessary to consider the timing of the benefits and the certainty associated with their achievement.  

It is not possible to be totally certain on the achievability of benefits, so valuers tend to vary the key assumptions on which the achievement of benefits is based.  This yields a range of benefits and consequently values.

Valuation methods

Valuation methods need to be aligned to the purpose and the development status of the asset being valued.  Normally used valuation methods include: 

Asset based methods reflect the value that could be realised from the disposal of the asset, or the assets of the business being valued.  This value depends on whether the sale is being done on an orderly or ‘going concern’ basis or on a financially distressed basis.

Income based methods involve discounting the cash flows expected to be generated by a business using a discount rate or using a single factor, capitalisation rate to convert expected future maintainable earnings into a value.

Comparable company or transaction based methods involves using comparable company data to value future expected benefits.

In early-stage technologies qualitative and scorecard methods are often used along with valuation methods which focus on exit values.  A key consideration in such businesses is that investors assume additional risks for which they expect returns.

Variants of the above methods have been developed for specific industries, and adaptation continues.  

Rules of thumb are often used in the technology and healthtech sectors.  These emphasise using key value drivers such as customer numbers or annual recurring revenues to derive value on the basis that economic value is dependent on such drivers.  

With disruptive technologies in the healthtech sector, time required to create market awareness and the market share which could be achieved in a specified period are important considerations.  An addressable market approach is often useful for such valuations.

When investments create platforms for further investment or ‘tack on’ acquisitions, and options for organic growth, option-based valuation techniques are often used.

In valuing drug and pharmaceutical businesses, it is necessary to consider the development time which would be required, regulatory approvals and the probability of success.  This has resulted in accepted risk-based valuation methods.

Values assessed using the above methods provide a range of values.  It is useful to validate results derived by methods to provide a range of validated and reasoned values. 

Consideration of the above brings discipline to the art and science of valuation.