There are many reasons why you might need to calculate the value of a company. You might be buying or selling a company, investing in its stock, or looking for funding for your business. In every case, you’ll need to figure out what the business is worth in order to make a decision.
For example, if you’re purchasing stock, all you need to do is decide if you think it’s worth investing. However, if you plan on buying or selling a company, all parties need to agree on a “fair value,” and this can get more complicated given that there are opposing interests. Whether you’re thinking of doing it yourself or hiring a professional, you need to know the basics of company valuation to understand what kind of deal you’re getting.
In this guide, you will learn about the main approaches to company valuation, what aspects they consider, and some of the techniques available for each approach. You’ll also learn about the advantages and disadvantages of these valuation methods and how you can use tools like Microsoft Excel or Google Sheets to calculate a company’s value using multiple valuation methods.
What is a Company Valuation?
A company valuation is an assessment of what the company is worth. There are many possible approaches to valuation, but the most popular tend to focus on income, assets, or market value. For a comprehensive valuation, multiple methods are usually used, and these will depend on multiple factors.
Among other things, the chosen valuation methods will depend on the industry, the business model, and the purpose of the analysis. For example, your interests differ depending on whether you’re buying or selling the company, so this is likely to affect your valuation methods. In the first case, you’ll favor methods that result in a higher value for your company.
In the next section, you have an overview of the most common approaches according to the aspects they consider. Additionally, you have a summary of the advantages and disadvantages of some of the most popular company valuation methods.
Company Valuation Methods
As mentioned, there are many possible ways to calculate the value of a company. However, some methods are more accepted and popular than others. Overall, a wide range of methods could be appropriate in different circumstances: from extremely simple valuations, such as those based purely on the company’s book value, to more complex calculations, such as the value of discounted cash flows.
The most popular approaches are those that focus on income, asset, or market value. Within the market approach, the focus is on relative value, considering comparable companies or similar transactions. However, there are also approaches concerning equity, liquidity, or debt, as these may be more relevant in some circumstances. Below, you have an overview of three of the most common valuation methods, including their main advantages and disadvantages.
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One of the quickest and simplest valuation methods is the company’s book value, sometimes referred to as the net asset value. In some contexts, net asset value and book value are used interchangeably. However, in many cases, net asset value is relevant only to mutual funds.
Overall, book value is probably one of the most unreliable methods, as it takes an overly simplistic view of the issue. It is calculated by subtracting all liabilities and intangible assets from the sum of all assets.
This method is sometimes used because it’s easy to calculate from data available on the company balance sheet. However, it can be quite unreliable as it provides a very limited view, which is also greatly affected by accounting principles and practices.
Another quick and popular valuation method is market capitalization. The calculation is a simple multiplication: the price per share times the number of outstanding shares.
However, market capitalization is not a particularly stable or reliable indicator of a company’s value. The price of shares changes based on multiple factors, some of which are completely external to the company. Market sentiment is fickle, and investors are prone to overreact to certain types of news or indicators.
Discounted Cash Flow (DCF) and How Is It Calculated?
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Discounted Cash Flow
Discounted cash flow is a more complex valuation method that focuses on income. Specifically, it uses the projections for future cash flows and discounts them using the selected rates. This provides an estimate of the investment’s present value based on the assumption of the time value of money. In other words, the dollar you have today is worth more than the one received tomorrow, as you can invest it.
The discounted cash flow method is very popular, as it estimates the value of the investment rather than the company itself. The result is a value that can serve as an indicator: if the value for DCF is higher than the cost of investing, it’s probably worth considering. However, it’s not necessarily appropriate to use in every case. The calculations rely entirely on estimates, both for the cash flow projections and the discount rate. This method has an inherent risk; if the cash projections turn out to be off, you could be looking at a very different return.
For a more detailed explanation and step-by-step instructions, take a look at this guide on Discounted Cash Flow Analysis.
As you have seen, calculating the value of a company is tricky. There are many aspects to consider and multiple methods available for each aspect. The main approaches tend to focus on income, assets, or market value, but others place more weight on the analysis of comparable companies. In order to ensure that you’re well-informed before making a decision, it’s important not to rely on a single valuation method. Fortunately, by using spreadsheet software together with a tool like Layer, you can synchronize and manage your data, so you can run multiple scenarios and analyses at the same time.
You now know about the main approaches to company valuations, as well as the most popular methods used to calculate a company’s value. You also know how Microsoft Excel or Google Sheets can help you automate the calculations, so you can use multiple methods for a more complete assessment of the company’s value.