MCDA applies one or more of three basic approaches to arrive to the value of a business:
- The going concern approach
- The asset based approach
- The market approach
The nature and characteristics of the business and the objective of MCDA’s engagement with the client determines which approach, or approaches, are most applicable in determining the value of a business.
The Going Concern Approach
The going concern approach is usually employed to determine value where a business is believed to be viable as a going concern. The most commonly adopted methods are discussed below. These methods, whilst described distinctly, are variations of each other as they are premised on the same underlying principle that value is prospective.
Capitalization of Maintainable Earnings
Focuses on the ability of a business to generate earnings by examining its operating characteristics. A capitalization rate or multiplier is applied to the maintainable earnings of a business to derive the going concern value. Maintainable earnings are defined as earnings from normal operations of a business which can be reasonably maintained given current and projected potential revenue growth of the business. The multiplier encompasses the rate of return which considers risk assessment relative to achieving the projected growth level. If redundant assets exist, MCDA identifies them and suitable adjustments are made to the valuation.
Discounted Cash Flow
This method involves an estimate of future free cash flows on year by year basis. It applies an appropriate discount rate on the projected free cash flow. Projected free cash flow is defined as the amount available to finance planned expansion, reduce debt, pay dividends or repurchase equity. The discount rate takes into account all future business and operating risks of a business. If redundant assets exist, MCDA identifies them and suitable adjustments are made to the valuation.
The Asset Based Approach
This approach is most commonly used to determine a minimum value for a business by determining the aggregate value of its net assets (i.e. assets less liabilities as of the valuation date). The two methods used under this approach are as follows:
Going Concern Value
In case a business is a going concern but has no apparent intrinsic value (i.e. it is not generating an acceptable return on its capital), the going concern value of its net tangible assets can be used to value the entire business. The going concern value of net tangible assets is an amount equal to the aggregate value of all tangible assets determined on the basis of “value in use”Â less all liabilities. Under the “value in use”Â basis, operating assets are viewed as a pool of assets in specific use of the operations of the business.
Where a business is not considered viable, its net tangible assets are valued on the basis of their liquidation (or break-up) value. Liquidation value is not considered a principal valuation approach, but rather a technique for assisting in the valuation of holding companies with investments in operating business concerns, or where a business is not viable.
The Market Approach
This approach uses the Guideline Company or similar transactions methods.
The guideline company approach focuses on comparing the risk profile and growth prospects of a business to similar (or “guideline”Â) publicly-traded companies, and bases the valuation on the value attributed to these companies.
Consideration is given to prices paid in recent transactions that have occurred in the relevant industry or in similar related businesses. This method is used rarely in the Middle East due to the lack of publicly-available information concerning such transactions.