Business valuation methods
Company valuation is a complex task. Due to asymmetrical information between the buyer and the seller, this task and the following negotiations are most of a bone of contention. Valuation aims to determine the value of a company, regardless of the company’s capital structure. Thus, the objective is to assess the company intrinsic value, the one a buyer would pay knowing every available information on the company.
Firstly, before valuing a company, it is mandatory to understand the company’s business model and its environment. This step should be realized by an expert who is familiar with the company’s sector. Secondly, one needs to analyze historical financial statements and financial forecasts by including in his analysis future trends that will affect the market where the company is evolving.
Several valuations methods can be used regarding the company’s profile. The aim is to determine a price that will be used during negotiations between the buyer and the seller. Each method having its own advantages and drawbacks, the idea is to select the most relevant method.
It is important to remind that valuation aims to define a price range, not a single price. In addition, a company value is not only defined by the valuation: several others elements such as synergies or market situation could spur a buyer to pay a premium.
Valuation using the multiples
The first method is the multiples method. The approach is based on the no arbitrage rule: two identical assets should have the same price otherwise one can earn a riskless profit. Thus, two companies having similar characteristics (business model, revenue, localization, etc.) should be valued with a similar multiple. There are two types of multiples: comparable multiples, which use data from listed company and transaction multiples which use data from past transactions.
Company value can be related to several financial aggregates, depending on the company’s market specificities:
- Earning Before Interests Taxes Depreciation and Amortization (EBITDA)
- Earning Before Interests Taxes (EBIT)
Equity value can be associated to an aggregate coming after interests payment, such as the Net Income. Equity multiple divided by net income is called the price to earnings ratio (P/E ratio).
Several steps are required before computing a multiple. First, one needs to create a sample of comparable companies, the peer group. Similarities with the analyzed company can be linked to several fields such as activity, sales, growth rate, localization or financial structure. The closer the similarities, the more relevant the multiple.
Once the sample is prepared, one has to link the company value of each company to its respective aggregates in order to compute multiples. Once this step is over, one needs to calculate the median or the average of those multiples: the value of the company is equal to the multiple times its appropriate aggregate.
The second approach with multiple is the precedent transactions. It is mandatory to calculate the average or median of several multiples and to multiple them to the appropriated aggregates linked to the company one aims to value.
The multiple approach main drawbacks are the lack of information on precedent transactions or on companies having similar characteristics. Thus, the more expertise an expert has on the market of the company, the more reliable his information will be, which will lead to a fair valuation.
Valuation using the Discounted Cash-Flow
This method of valuation – known as Discounted Cash Flow (DCF) – consists of considering that a company is now worth all the revenues it will generate in the future (Free Cash Flow to the Firm), extrapolated to infinity and discounted at the rate of return that an investor could expect.
Like for the other methods, this approach aims to evaluate the company regardless of its capital structure.
In order to use this method, one must first compute the firm expected cash flows of the firm for a time horizon of 5 to 7 years which is the period during which the analysis is still relevant and realistic. After this first step, it is necessary to discount the estimated free cash flow to the Weighted Average Cost of Capital (WACC).
It will then be necessary to determine a terminal value to materialize the “sustainability” in the very long term of the company. The latter will also be discounted at the weighted average cost of capital. Thus, by adding all the discounted FCFFs and adding the discounted terminal value, we obtain a valuation of the company.
This approach has several advantages. Indeed, data needed to compute the free cash flows are easily available which make this approach suitable for a large panel of companies. In addition, one can create scenarios because assumptions used with this method can be changed, which make this approach flexible. However, the approach also faces drawbacks. While the method is flexible, assumptions’ variation can lead to uncertainty making the valuation not reliable due to high sensitivity. Moreover, a company may face an exceptional event which would make the model unreliable. Finally, the DCF model is not designed for every company: company with negative cash flows cannot be valued with the DCF method because the valuation would be negative.
Valuation using the Net Asset Value
This approach is a picture of the company’s balance sheet: it is based on a company’s assets and liabilities at a given moment. This method provides a company valuation by reappraising each component of the balance sheet, also called the net asset value.
This method is helpful for companies having a consequent amount of assets and liabilities such as companies involved in industry or real estate. The asset method is however not recommended for low capital industries, start-ups, and services companies.
Reassessing each asset is mandatory because their value on the balance sheet is their historical cost which could have varied since the time they were purchased. Thus, assets must be revaluated following existing rules and values (liquidation value, market value, etc.). In addition, one needs to make additional reappraising for several elements such as off-balance sheet items.
The main advantage of this approach is its simplicity: the company estimated value is simply the sum of its revaluated assets minus its liabilities. Nevertheless, because this method is based on the company’s balance sheet, it does not include any income statement’s elements and no concept of margin or potential profitability.
Valuing a company is not only about fixing a range of prices; it is also about preparing a reasoning which will help justify the selected price. Thus, through its work, one who is performing valuation must highlight every available element on which he can rely in order to explain and defend his approach. During all the valuation process, one should be helped by an expert in order to follow a strict methodology, which is detailed here.