Business Valuation

We start by listing situations when business valuation models are needed in accounting: when valuing shares of a private company in an equity portfolio, in accounting for a takeover, and in performing an impairment test of goodwill. We proceed to discuss the two main approaches to business valuation—the ratio-based approach, and the discounted cash flow (DCF) approach. We discuss a few variations of these approaches, distinguishing between models that value the entire enterprise (enterprise valuation), and those that value just the equity (equity valuation). For DCF models, we distinguish between one-stage, two-stage, three-stage and general multi-stage models. General multi-stage models are based on cashflows projected for a fixed number of years—the planning period—followed by a terminal value, representing the projected value at the end of the planning period. We discuss different approaches to estimating the terminal value. For DCF models of enterprise valuation, we discuss three approaches—WACC, adjusted present value (APV), and residual income valuation. The WACC model discounts projected free cash flows available to both debtholders and shareholders. These cash flows are discounted using a weighted average of the required return demanded by debtholders and shareholders, weighted by their respective proportions in the enterprise’s capital structure.