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What does it mean to valuate a company?
A company valuation involves estimating the economic value of a company or a company division. Businesses can be valued to determine the fair market value for various reasons, such as for sale, partnership agreements, taxation, and even for divorce proceedings. A professional business evaluator is often called upon by owners to estimate the value of their business. But what if you want to do your company valuation? What company valuation formula should you use?
Company valuation basics
Company valuation is a common topic in corporate finance. Companies usually conduct a company valuation when looking to sell all or a portion of their operations or when they are looking to merge or acquire another firm. Also, tax reporting relies on valuation.
The valuation of a company may encompass an examination of the management, its capital structure, its assets market value, and its future earning prospects. However, valuation tools can differ across companies, industries, and evaluators.
Typically, companies are valued by analyzing financial statements, discounting cash flow models, and comparing their financial statements to similar companies.
Why valuation matters
When buying or selling a business, it is necessary to figure out how much it is worth. But that’ not the only reason to calculate company valuation. Other reasons include:
- You need to know how much your company’s worth is to get financing or investment.
- If one partner want’s out of a partnership, you need to find out the value of that partner’s share of the company.
- If you’re divorcing, your business may need to be valued to ensure equitable distribution of assets.
There can be controversy surrounding a company’s valuation. For instance, a business partner may want a higher price for his stake than what you think it is worth. These are the reasons why objective valuation methods are essential.
Company valuation formulas or methods
Business valuation based on stock price
In the case of public companies, calculating a market value can be pretty straightforward since you can use the stock price. Consider a company with 500,000 shares publicly traded, each selling for $20. This would make the total share value $10 million.
This is the easiest way to carry out company valuation, but it’s not the most effective. The share price is determined by the perceived value of a company, which may not accurately reflect its true worth. This is one reason why stock prices fluctuate. Valuation solely based on stock prices is risky for the following reasons:
- In some cases, the share price may be determined by the success of a new product soon to be launched. The product may not perform well when it debuts, and shares could decline.
- Likely, the investors purchasing the stock did not make a serious assessment of the company.
- Investors may expect future growth that does not materialize.
- The company’s growth the previous year may lead investors to believe it will continue this year. However, this is not always the case.
- There is a possibility that the stock price reflects temporary lousy news and not its genuine value.
- Share prices may not mean much if the company is not heavily traded.
If your small business is not publicly traded, which most are not, you have to use a different method to calculate its value.
Valuation of based on comparison to competitors
Comparing one company to a similar one is another way to establish its value. For example, if you are selling your company, you can check the value of similar companies in your area in the same industry and estimate yours based on that.
In order to obtain these figures, you may have to look for similar businesses that have recently been sold and find out their value. If the information is available, a price/earnings ratio could also be used.
This method is not without its limits though:
- Comparable sales may not be available.
- Unless the sales data is recent, some values might not reflect current market conditions.
- It may be difficult to figure out how to modify the formula to account for factors such as older equipment or better-trained employees.
Through the valuation of assets
This is a straightforward method of appraisal that doesn’t require complex math. You can find the total value of your business by adding up your assets and subtracting your liabilities. You can use any of the two approaches below:
- Going concern
The assumption here is that you won’t be selling off major assets and that the business will remain up and running.
- Liquidation
This method values a business on what it would be worth if you closed it, sold its assets, and paid off its debts. Liquidation sales usually do not bring the market price, so this gives you a lowball valuation.
In the asset-based valuation method, the downside is that a business is more valuable than the value of its equipment, real estate and inventory.
Discounted cash flow valuation
Discounted Cash Flow (DCF) provides a more accurate measure of a company’s value. In contrast to asset valuation, DCF valuation requires more number crunching. However, it’s much more important to look at how much cash a company will generate in the future to assess its actual value.
Cash should be used to value a business because cash is what business owners need and want at the end of the day. You can’t pay the bills, landlord, or employees if you make good money, but your cash flow is negative.
How to calculate DCF
- Estimate your future revenue. A simple growth forecast can be used, or factors such as price, volume, competition, and the number of customers can be considered. The second option takes more time and effort.
- Project your capital assets and expenses. When combined with revenue, this allows you to calculate cash flow for future.
- Calculate the terminal value of the cash flow. For instance, after five years, how much will all the future cash flows be worth?
- Finally, calculate the net present value using standard formulae based on the terminal value.
Valuation using startup cost
Though it is not widely used, another method of valuation is to calculate what a company would cost to start up from scratch. For example, if you’re considering purchasing a manufacturing company, you would want to find out what it would cost to buy equipment, lease space, purchase vehicles and hire a workforce. This will help you figure out how valuable a company is.
This approach has the disadvantage of not considering the company’s income or cash flow in the future, just like asset-based valuation.
Valuation by revenue multiplication
Similar to cash flow, revenue gives you an idea of how much money the business will make. A company’s value can be determined by multiplying its current annual revenue by a number such as 0.5 or 1.3.
You cannot choose your multiplier. Each industry has its own standards: 2.2 for food processing and 1.7 for household products, for instance. Applying the revenue multiplication method to a company with N800,000 revenue gives a value of N1,760,000 in the food-processing industry but N1,360,000 in household products.
However, instead of using the revenue multiplication method by itself, business analysts may use it to determine a company’s value by setting a maximum ceiling on it.
Debt and surplus
When you calculate the value of a company, you may still need to make some adjustments. Most methods do not consider the amount of cash on hand or how much debt the company has. You should consider these factors before setting a final value.
For instance, let’s say you intend to sell your company, and the discounted cash flow formula put its net value at N8,560,000. However, you have an outstanding debt of N2,000,000. With the company’s obligations, the buyer may only be willing to pay N6,560,000.
Also, a surplus of cash on hand may enable you to raise the price of your business to reflect the surplus cash. Alternatively, you could decide to keep the excess and let the buyer keep the rest.
Get a Professional
It’s better not to fly solo when you are valuing a company. Valuation is a specialized skillset even if you have a strong knowledge of finance and spreadsheets. Professional valuators know how to apply the correct multipliers, the most recent comps, as well as the dynamics of the market to your unique situation.
In addition, professionals are objective. You should be aware that your skin in the game can impair your judgment when planning an exit strategy or buying your dream company. It is vital to get a professional’s cold-blooded assessment to prevent mistakes from being made.
In conclusion; choosing your company valuation method
Most of the time, the goal behind your valuation will determine the best method to use. For instance, when the goal is to sell, you want to apply the technique that gives you the best price realistically. If you want to buy, you want to get the lowest price without the seller saying no.
Therefore, identify the reasons for your need for a valuation. You need to know if you will be profitable if you are considering a company purchase. But your needs are different if the aim is to sell your business.
There are some other questions you should ask yourself to guide your decision. Do you have a lot of assets? A business that owns valuable property such as land or patents might have a higher book value than what you would be worth if you were valuing it via discounted cash flow.
Is there a norm for your industry? An asset-based valuation is an appropriate option for manufacturers who have lots of equipment. But professional service providers require little to no equipment, so assets are meaningless here.
Trying different methods to see what values you get isn’t impossible if you are willing to put in the time and effort.
