Could you tell the exact value of your business or company? Unfortunately, most people can't answer this question because they haven't worked it out yet. However, estimating an accurate business valuation is essential because underestimating or overestimating the worth of your own business can very well be detrimental to its success.
What is Company Valuation?
Company Valuation is the procedure to determine the company's worth, including the evaluation of all aspects of the business. It refers to estimating the economic or intrinsic value for a company, a business, or a particular business unit.
Company Valuation Objectives
There are various objectives behind this procedure to determine the fair value of a business; some of those are:
- Investing in or buying a company – The investor or buyer will estimate the value of the company they are considering to invest in to facilitate negotiation as well as evaluate its profitability, return on investment, and impact the deal will have on their overall portfolio.
- Selling a company – The seller will calculate the company's worth to decide the correct offer price and facilitate negotiation.
- Merger or Acquisition – The merger and acquisition consolidate the value of one company to another; the team evaluates the worth of the company they are merging with or acquiring to gauge whether this deal will strengthen the company's value and profitability, or weaken it.
- Raising funds – Raising funds either by pitching some top investors or floating shares in the stock exchange. In both cases, the company valuation plays a crucial role. In the former scenario, the investor will need to know the company's current and forecasted worth. Whereas, in the latter case, the company valuation will be necessary for both the people raising funds to decide the appropriate competitive share price and the ones buying the stocks to estimate future return and make the correct call.
- Legal Requirement – Annual audits, taxation or tax reporting, acquiring licenses, performing transactions internationally in multiple currencies, getting a loan from a bank, credit ratings, and registration at various forums can require company valuation to know the intrinsic value or worth of the company, how much risk it can bear, or where it stands in terms of national or international markets.
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Why is a Company Valuation Important?
Conducting valuation is no piece of cake. Valuating a company is a complex, technical, and multistep process that can be executed using different methods and approaches.
It includes the estimation and analysis of various elements, including the company's current and forecasted financial position, competitive position, industry analysis, relevant economic factors and their impact on business, market trends, capital structure, product or service position, customer base, management skills, cashflow, brand positioning, future plans, and numerous other components.
Conducting a valuation is a crucial procedure that comprises quantitative measurements as well as qualitative assessments. However, different valuation methods include different estimation elements that are applicable for different types of business models. Therefore, a business appraiser should take a wise approach on the basis company's business model, valuation objective, and strategy.
Furthermore, it is usually recommended to use more than one method to analyze the accuracy of results as each one has its advantages and disadvantages. In addition, assumptions are also critical factors in valuation where appraisers have to make key assumptions to facilitate the valuation process by analyzing the economic factors and competitive positions; such assumptions can be for growth rate, interest rate, inflation, etc.
How to Calculate Company Valuation?
There are several ways a company can be valued. Some of the most popular and reliable ways are:
- Market-Based Approach
- Asset-Based Approach
- Income-Based Approach
This approach includes comparing a company or business to be valued with a similar business in the same sector using industry benchmarks. Numerous parameters or multiples, that can be extracted from the company's financials, are used to measure the company's value.
In addition, this approach includes the following techniques for company valuation:
- 1. Market Capitalization
This is the simplest technique where a company's worth is measured in terms of outstanding shares value. The value can be derived by multiplying the company's share price by the total number of outstanding shares.
Market Capitalization Formula = Current Market Price per share * Total Number of Outstanding Shares
For instance, company ABC's share is currently trading at $50, and it has 8 million outstanding shares. Then its market capitalization value will be $400 million.
- 2. Time Revenue Method
This includes analyzing the company's revenue stream and forecasting future revenue by applying a multiplier based on historical data, industry benchmarks, and the economic environment.
For example, macro-economic and industry analysis has set the multiplier of 2x for FMCGs for the next 2 years. That means an FMCG company with current revenue of $50 million will generate $100 million and $200 million in consecutive years. With this forecast, an appraiser can work out its gross and net profits and assess its profitability trend.
- 3. Price-to-Earnings (P/E)
The Earning Multiplier or Price-to-Earnings ratio (P/E) is considered relatively more accurate than the time revenue method. It can be used to get a more accurate reflection of a company's value as the company's earnings are more relevant indicators than the revenue stream to estimate the company's worth. Using this method, the P/E ratio is used to calculate the company's value.
P/E Ratio = Earnings per share/Market value per share
For example, if the P/E ratio of a tech company is 10 and its projected earnings are $300,000, the business worth will be $3 million. Although it is easier to calculate and a widely used technique, several accounting adjustments and capital structure can cause distortions in earnings projections. Hence, it can be a reliable indicator when profit streams are consistent.
- 4. Price-to-Sales (P/S)
Unlike the Price-to-Earnings (P/E) ratio, The Price-to-Sales (P/S) ratio is less distorted by adjustments and capital structure. It compares a company’s stock price to its revenues.
P/S Ratio = SPS/MVS
MVS = Market Value per Share
SPS = Sales per Share
This can be applied by businesses with inconsistent profits as an alternative to P/E to estimate a company's worth.
- 5. Price-to-Book (P/B)
The Price-to-Book (P/B) or the Price-to-Book Value (P/BV) derives the company's worth using the book or accounting value of the business's overall assets and the book value per share (BVPS).
P/B Ratio = Book Value per Share/Market Price per Share
This can be a reliable accurate indicator, particularly for companies whose earnings rely on the value of their assets.
- 6. EV/EBITDA
Enterprise value/EBITDA is a popular valuation multiple in the finance industry and the most widely used one. The enterprise value consists of the sum of the value of debt, equity, and cash balance, while EBITDA consists of the earnings before interest, tax, depreciation, and amortization.
Enterprise Multiple = EV/EBITDA
EV = Enterprise Value = Market capitalization + total debt − cash and cash equivalents
EBITDA = Earnings before interest, taxes, depreciation, and amortization
Therefore, EBITDA is considered a more relevant parameter as it is not adjusted with distortions such as taxes, capital structure, etc., reflecting a more reliable picture of the company's value. It is usually used along with, or as an alternative to, the Price-to-Earnings (P/E) ratio.
Using this approach, a business value is based on the Net Asset Value (NAV) derived by subtracting debts and liabilities from the fair market value of everything a company owns such as equipment and inventory.
NAV = (Assets - Liabilities) / Total number of outstanding shares
The fair value of depreciating and non-depreciating assets may vary substantially from book value due to depreciation and acquisition value due to market trends, respectively. That's why measuring the asset's fair value is a vital and critical aspect of this approach.
This provides a value that a business owner will require to establish an identical business. It can be a starting point or a way to determine the bottom-line value. However, a company's true worth will probably be higher than the net value of its assets due to the nature of business, a competitive edge, or goodwill.
Moreover, estimating a business value in terms of its Liquidation Value is another aspect of this approach, which is the money a business will get if it pays all of its liabilities by liquidating its assets. It is usually calculated when the owner decides to sell a company or shut down the entire business or a specific unit.
Net Liquidation Value Formula = Liquidation value of Assets – Liquidation value of Liabilities
This is a more complex and technical yet reliable and accurate approach that includes calculating the business's intrinsic value using the Discounted Cash Flow model (DCF).
Most analysts or appraisers use this technique to forecast a business's future profitability and financial projections. This model involves calculating any projections of future cash flow a company can generate based on historical data, business dynamics, and industry and economic analysis. Then, discount forecasted cash flows to present value using estimated growth and the firm's weighted average cost of capital (WACC).
This technique can be utilized to achieve almost all the valuation objectives.
Suppose you are an investor and want to buy a company offered at $50 million, which will be your cash outflow at year 0. If your appraiser projects the company's cash flows and its present value at $80 million, that means your Net Present Value (NPV) will be $30 million and you should go for the deal.
Along with NPV, you can also measure your Pay-Back Period (PBP), which is the time taken to cover your initial investment and achieve a break-even.
Payback Period = Initial Investment / Annual Cash Flow
The DCF method includes vital information and thorough calculations to achieve realistic results. Therefore, it is mainly used to value businesses that expect inconsistent profits.
Since multiple assumptions are considered, such as interest rate, tax rate, inflation, etc., it is also recommended to use sensitivity analysis for your results. It includes comparing the base case with the best case when the rates are all in your favor and the worst case when facing unfavorable conditions.
In addition, it will reflect the effect the change in assumptions can have on your profitability. For instance, in the diagram below, the effect of change in input variables (i.e., Revenue Growth and EBITDA) and output variables (i.e., Share Price) have been analyzed.
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There is no one perfect valuation method for all companies or businesses. When selecting one, a business appraiser should consider all available information, knowledge, and experience as it is a crucial procedure that allows you to determine your company's worth supported by numerical arguments and logical reasoning
It can be said that the Discounted Cash Flow model (DCF) is a combination of techniques which is why its results are considered more reliable. However, numerical data isn't sufficient to assess the company's worth. Therefore, one should consider other qualitative environmental factors affecting your results, including market analysis and competitive positioning analysis.