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Company valuation methods can be divided roughly into two main categories. One is substance value approach, which is based on the value of the company’s assets, and the other is future earnings approach, which is based on the expected future earnings of the shareholders. The assets tied to profitable business are often more valuable than their book value.
The substance value can be considered as the minimum value of the company. It is equal to the amount of cash that would be returned to the owners if the company stopped operating, paid its debts, and liquidated its assets.
When determining the value of future earnings of the shareholders, it is important to understand that the value can be different for different owners. For example, a shovel can be more valuable to one person than the other because of the ability to use it in a more efficient way, or because there is more digging to do. This means that different people are willing to pay a different price for the same shovel. The more reliable company valuation methods adjust for this difference in value.
The same applies to companies: the value of the company depends solely on the company’s ability to create value to its owners. If someone could make the company generate more income than its current owners can by utilizing pre-existing sales channels, the expected future earnings for this person are higher than for the current owners. Therefore, it can be worth to pay a higher price for the company than the expected earnings are for the current owners.
For these reasons, company valuation is never an exact science. The value of a company is always contextual and depends on the observer. This is why company valuation methods – and company valuation tools – need to be chosen according to the situation. Furthermore, the value of a company can be subject to sudden changes even if its operations remain the same. For example, in a situation which a major potential buyer withdraws its offer and decides instead to buy another similar company, the value may change overnight.
Therefore, it is important to be able to determine the value of a company by testing different assumptions. What would be the value if a potential buyer could increase our sales significantly using their sales channels? What would be the value if we made a certain kind of investment? How much would the value change if we were able to permanently decrease our stock levels 30 percent from the current situation?
In the end, the value of a company will be determined by the buyer and seller together. Reaching an agreement becomes possible when the buyer has a higher estimate of the value than the seller. When the price is settled somewhere between the estimates of the buyer and the seller, both parties are better off compared to a situation where no agreement is reached.
Company valuation methods based on future earnings
There are numerous company valuation methods for determining the value of future earnings. The most important ones are discounted cash flow method (DCF) and different valuation multiples. The DCF-method is based on the net present value of a company’s future cash flows, whereas when using valuation multiples, the value of the company is estimated by comparing its financial figures to those of other companies in the same industry. Both methods have their strengths and weaknesses. The company value estimated with the DCF-method is only as accurate as the input estimates used in the model. Valuation multiples method, on the other hand, provides information about the average valuation of similar companies, but does not consider company-specific characteristics or future potential.
More about DCF method
The discounted cash flow (DCF) method is generally considered one of the best company valuation methods. Its biggest strength is that it considers company-specific future prospects, while many other methods, e.g., multiples method, compare the company to the industry averages. The future cash flows are discounted to the present value and the value of the business is calculated based on this.
Discounting might be a confusing term, but it simply means calculating the present value (i.e., the value today) of money received in the future. For example, if you deposit €1000 into a bank account that offers a 5 % annual interest, you would have 1.05*€1000 = €1050 in one year. In other words, €1000 today is worth €1050 in one year. What about in two years? The €1000 today would then be worth 1.05*1.05*€1000 = €1102.50. So how much would we need to deposit today to receive €1000 in one year? The answer is simple: just reverse the calculation. Deposit today = €1000/1.05 = €952. We just discounted the value of future cash flow. In this case the 5 % interest rate is called discount rate.
The same concept applies to companies: The value of a company today is equal to the present value of its future earnings. So, to calculate the company value, we need to estimate the future earnings, the discount rate, and calculate what they are worth today using discounting.
Below you can see the fours steps as well as a graphical illustration of the DCF method.
Four steps of the DCF method:
- Estimation of the future cash flows over a certain period of time T. Usually T = 5 – 10 years.
- Determination of the discount factor. Usually the weighted average cost of capital (WACC) is used as the required rate of return.
- Determination of the terminal value of the company. This is the value of the cash flows happening after the year T, discounted to year T.
- Discounting of the value of the cash flows for years 1-T, as well as the terminal value, to present day. The sum of the discounted cash flows is the enterprise value.
The main weaknesses of the DCF method are its complexity and its vulnerability to incorrect assumptions. Even a small variation in the cash flow assumptions or in the discount factor can cause significant variation in the results. This means that DCF method is suitable for use only when the future cash flows and the discount factor can be estimated with relatively good accuracy.
More information on DCF and technical details of the method.
Company valuation methods based on substance value
The most common substance-based valuation method is the book value (BV) method. Book value of equity is the balance sheet value of company’s assets less the company’s liabilities. In other words, this is the amount the shareholders would get if the company stopped operating, sold all its assets, and paid its debt.
Example: Company XYZ has been producing shovels and is now going to stop operating. It will be sold and liquidated. The machinery used to make shovels is worth 250 000€ and their brand and patents are worth 5000€. The value of total assets is 255 000€. Company XYZ has a loan of 50 000€ from the bank.
The book value of the company is 255 000€ – 5000€ – 50 000€ = 195 000€
The problem with the book value method is that it ignores the company’s profit-making ability completely. If a company is generating profits, and perhaps showing constant growth, its assets are more valuable than their book value. Moreover, in case of, e.g., a holding company, book value method does not provide reasonable results. The method also may ignore intangible assets such as patents and copyrights, unless the costs associated with them are capitalized on the balance sheet. One alternative is to use adjusted book value method, in which the value of assets is adjusted to fair market value instead of using the book values. However, the same issues remain.
Regardless of its obvious shortcomings, the book value method is widely used in buy-sell agreements due to its clarity and simplicity. However, it is important to note that companies are rarely acquired with liquidation in mind. Book value is a useful company valuation method for establishing a minimum value for the business sold. The final valuation results can then be adjusted properly.
Some of the problems associated with the book value method can be a solved with a goodwill adjustment, which is a premium that is paid on top of the book value of equity. The problem is that in case of a private company determination of goodwill can be difficult. Thus, the book value method is best suited for situations where the company does not hold any significant intangible assets, or the goal is to simply liquidate the company because of ceased operations.
Alternative company valuation methods
So far we have covered some of the most common company valuation methods. However, in some cases none of the aforementioned company valuation methods are applicable. This can be the case if, for example, the company experiences negative earnings and cash flows. In this case, the ratio of EBIT-% to price/sales of peer companies can be used as a benchmark for estimating the value of the business. This method relies on the assumption that the company will reach the average EBIT-% of the industry in the future.
Another special case is the valuation of pre-revenue companies, e.g., start-ups. In this case the so-called scorecard method can be used. Like many other methods, the scorecard method relies on the statistical information of past deals done within the same sector. In the scorecard method factors such as strength of the management team and size of the opportunity are estimated and compared to those of the companies sold before.
More information on the scorecard method.
Further reading on company valuation methods
For readers interested to gain more in-depth knowledge about company valuation, the following readings are recommended: