In this article we’re going to explain the different methods of business valuation, and hopefully provide you with some actionable steps. Of course, this will be a short summary of what is a very in-depth topic, and so it’s advisable to check out some additional resources on how to value a private company or speak to a specialist.
A real-estate example
What predators - financially strong companies that buy up other companies in mergers and acquisitions - do before taking over a target is to look at whether or not they’d be getting good value for money. That should be obvious, but it’s the methods of figuring out the value that’s the tricky part. We’re going to use real-estate as an example for now, because it’s fairly similar.
In buying property, you have the bottom-up bricks-and-mortar approach, the house-next-door approach, and the “value from a rental perspective” approach. All of these won’t necessarily give you the same number, but they’ll give you a range to work with. After that, it’s simply a negotiation as a buyer to get the lowest price possible, and the highest price possible as a seller.
So in the first method, you would do a sort of bottom-up estimation of the cost of the land and building over the property - again, just using real-estate as an example. So you would look at the prices of nearby houses, and even if they’re not exactly identical, it would give you a good idea of what someone is actually prepared to pay to live in the property. So you would calculate the future rent that the property asset might generate, and then bring it back into today’s money terms.
While it’s not exactly the same, a similar sort of three-pronged approach can be applied to valuing a business:
The asset based approach
You essentially take a company’s balance sheet as a starting point, look at the list of assets, and make some adjustments (as a buyer) whether you believe they’re safe or not, and come up with an asset-based valuation.
Of course, it’s likely you’re not buying the company to get rid of the assets, you’re likely buying the company for a longer term investment.
The asset-based value is basically the equivalent to the company’s book value, or the shareholder’s equity, with the liabilities being subtracted from the assets. The main hurdle to arriving to an asset-based valuation is the adjustment of net assets, which means the book-value of an asset may not necessarily reflect the fair market value.
The house-next-door/ratio-based approach
In this approach, you look at similar companies within the same sector, and consider their P/E (price-to-earnings) or price-to-sales ratio, and then come up with a comparative number for the company you’re looking at.
The P ratio is the relationship putting the current share price of a company, for example, plus one year’s earnings. So if a company had a P ratio of 10, you can say the value of the company is equal to multiplying that P ratio to ten times the earnings.
P = 10 * E
So then if you can come up with the right earnings figure, and think that 10 is the adequate multiple to apply to the company, you can come up with a value for P. This formula can of course be adjusted.
The discounted cash flow (DCF) approach
In this method, it’s similar to looking at the rental worth of a property in the future. The idea is that you want to forecast the earnings and cash flows that a company will generate, and then bring it back into today’s money terms. This requires a bit of talent for forecasting and projection.
This method is typically used by professional investors and analysts at investment banks for determining how much they’re willing to pay for share stocks, or buying the company entirely. To put it simply, the DCF analysis hinges on the principle that an investment now is worth an equal amount to the sum of the future cash flows it can produce, and each of those cash flows are discounted at their present value.
So as an example, let’s say somebody you trust offers you $1,500 to be paid in three years, and asks how much you’re willing to pay for it right now. So you would essentially need to figure out how much that $1,500 would be worth in three years, by calculating the rate of return your money would be compounded during the waiting period.