Company valuation, also known as business valuation, is the process of assessing the total economic value of a business and its assets. During this process, all aspects of a business are evaluated to determine the current worth of an organization or department. The valuation process takes place for a variety of reasons, such as determining sale value and tax reporting.
A business valuation is the process of determining the economic value of a business, giving owners an objective estimate of the value of their company. Typically, a business valuation happens when an owner is looking to sell all or a part of their business, or merge with another company. Below are the 6 ways to do valuation of the business.
- Book Value
One of the most straightforward methods of valuing a company is to calculate its book value using information from its balance sheet. Due to the simplicity of this method, however, it’s notably unreliable.
To calculate book value, start by subtracting the company’s liabilities from its assets to determine owners’ equity. Then exclude any intangible assets. The figure you’re left with represents the value of any tangible assets the company owns.
- Discounted Cash Flows
Another method of valuing a company is with discounted cash flows. This technique is highlighted in the Leading with Finance as the gold standard of valuation.
Discounted cash flow analysis is the process of estimating the value of a company or investment based on the money, or cash flows, it’s expected to generate in the future. Discounted cash flow analysis calculates the present value of future cash flows based on the discount rate and time period of analysis.
Discounted Cash Flow = Terminal Cash Flow / (1 + Cost of Capital) # of Years in the Future
- Market Capitalization
Market capitalization is one of the simplest measures of a publicly traded company’s value. It’s calculated by multiplying the total number of shares by the current share price.
Market Capitalization = Share Price x Total Number of Shares
One of the shortcomings of market capitalization is that it only accounts for the value of equity, while most companies are financed by a combination of debt and equity.
In this case, debt represents investments by banks or bond investors in the future of the company; these liabilities are paid back with interest over time. Equity represents shareholders who own stock in the company and hold a claim to future profits.
- Enterprise Value
The enterprise value is calculated by combining a company’s debt and equity and then subtracting the amount of cash not used to fund business operations.
Enterprise Value = Debt + Equity – Cash
To illustrate this, let’s take a look at three well-known car manufacturers: Tesla, Ford, and General Motors (GM).
In 2016, Tesla had a market capitalization of $50.5 billion. On top of that, its balance sheet showed liabilities of $17.5 billion. The company also had around $3.5 billion in cash in its accounts, giving Tesla an enterprise value of approximately $64.5 billion.
When examining earnings, financial analysts don’t like to look at the raw net income profitability of a company. It’s often manipulated in a lot of ways by the conventions of accounting, and some can even distort the true picture.
To start with, the tax policies of a country seem like a distraction from the actual success of a company. They can vary across countries or time, even if nothing actually changes in the company’s operational capabilities. Second, net income subtracts interest payments to debt holders, which can make organizations look more or less successful based solely on their capital structures. Given these considerations, both are added back to arrive at EBIT (Earnings Before Interest and Taxes), or “operating earnings.”
- Present Value of a Growing Perpetuity Formula
One way to think about these ratios is as part of the growing perpetuity equation. A growing perpetuity is a kind of financial instrument that pays out a certain amount of money each year—which also grows annually. Imagine a stipend for retirement that needs to grow every year to match inflation. The growing perpetuity equation enables you to find out today’s value for that sort of financial instrument.
The value of a growing perpetuity is calculated by dividing cash flow by the cost of capital minus the growth rate.
Value of a Growing Perpetuity = Cash Flow / (Cost of Capital – Growth Rate)
With a drop in valuation multiple, your business will have to increase its EBITDA by a meaningful amount so that you are able to achieve the same valuation you would have received at the peak. As such, unless you’re 100% certain that your business will grow for the foreseeable future, there’s a significant valuation risk associated with delaying a sale of the business or at least some partial liquidity event.
As such, if selling your business is a route you plan to take, it’s important to consider whether valuations are near the peak of a cyclical M&A market. This can help you determine when might be an appropriate time to contemplate either a complete or partial exit in order to maximize the valuation received for your business.