4 Business Valuation Methods

businessvaluationmethodsToday we will give you a quick overview of business valuation methods. This post is geared toward those with at least a little basic business or financial background, and will show a few common business valuation methods. Of course, the utility of business valuation methods is not limited to only large corporations and investment bankers. Startups and small businesses would benefit from knowing a bit about how business valuation works and perhaps could even consider a course in small business valuation. Alternatively, those in need of a slightly more advanced and thorough explanation and step-by-step walkthroughs will want to take a look at this CFA-Approved training in financial models and valuation for beginners that need more corporate finance or investor-type knowledge.

Big or small, business valuation is important for owners, so that they can better use some of these valuation methods to “speak” the language of finance-types. There are a lot of factors that go into determining the valuation of a company. Certainly revenues are a big factor but they are not the only factor in the valuation of a company.

If you keep up with business and financial news you will often hear about a company’s “valuation”. For example, Twitter recently listed its IPO with a whopping $18.1 billion market capitalization or $26 per share and is now trading for far more.

(If the previous sentence sounded like a foreign language to you then you might want to see my other post on “How does the stock market work?”).

So, how have people decided that a company based around a bunch of 140-character posts is worth billions? Through business valuation methods, of course!

Business valuation methods are the various ways to estimate the (somewhat) unbiased value of a business in terms of present value and the potential that a company has rather than just the current revenues. These are calculated using objective measures that look at all aspects of a business such as analysis of capital structure, earnings prospects, market value of assets, and sometimes an analysis of company management. This valuation is important to financial people and investors as it helps determine the economic value of a business and drive investment decisions.

4 Most Common Business Valuation Methods

  • Discounted Cash Flow (DCF) Analysis

  • Multiples Method

  • Market Valuation

  • Comparable Transactions Method

The above methods are based on some understanding of accounting.

Finance people and potential investors will generally look at the financial statements to evaluate a company including: the Balance Sheet, the Income Statement, the Statement of Cash Flows, and the Statement of Retained Earnings, so it certainly helps to know what they are. To get a better overview than what I can give you here, I recommend this 60-minute course on the basics of accounting.

Market Valuation Method

Market Valuation is the simplest way to value a publicly traded firm (firms that issue shares). These include large corporations registered on a stock exchange like NASDAQ or NYSE. Since they are publically traded, it is fairly easy to locate information about them since they are required to publish financial reports annually. Furthermore, to determine the value of a publically traded company you can easily calculate their market capitalization (aka “market cap”) by multiplying the company’s stock price (the price of a single share) by the number of shares outstanding for the equity market value.

Once you have that value then you adjust for the amount that it would sell for if the company were being sold. The price that buyers are actually willing to pay is not necessarily reflected in the share price. As a result, a company would sell for either a discount (a value under market value) or a premium (which is a value higher than market value).

Discounted Cash Flow (DCF)

This is the most thorough way to calculate the value of a company. A classic tool of MBAs, this method has two general approaches:

  1. Weighted Average Cost of Capital (WACC)

  2. Adjusted Present Value (APV)

These work by calculating the Free Cash Flows (FCF) of a company as well as the net present value (NPV) of these Free Cash Flows.

WACC

Here is the formula to calculate the discount rate (r) of the Weighted Average Cost of Capital (WACC). It uses the target equity ratio equity and the target debt ratio targetdebt.

The formula for the discount rate (r) of the Weighted Average Cost of Capital (WACC) is:

WACC

Where:

  • D = Market value of debt

  • E = Market value of equity

  • rd= Discount rate for debt = Average interest rate on long-term debt

  •  rle= Discount rate for leveraged equity (calculated using CAPM)

The formula for the Capital Asset Pricing Model (CAPM):

CAPM

Where:

  • rf= Risk-free rate of return for a theoretical investment without risk

  • rm= Expected market return

  • excessmarket = Excess market return

  • betaL= Leveraged Beta (Beta is a measure of Volatility/Risk)

Note: The risk-free rate comes from the Treasury bond rate at the time where the projections are being considered

Adjusted Present Value (APV)

The adjusted present value uses the Net Present Value (NPV), which calculates on the basis of being financed only by equity. After the NPV is determined, APV then factors in the benefits of financing by taking into account the present value (PV) of any financing benefits like tax shields such as those provided by deductible interests.

The NPV formula is:

NPV

Where:

  • FCF = Free Cash Flows

  • rd = Discount rate for debt = Average interest rate on long-term debt

Calculating this by hand can be pretty tedious so at this point you may want to look into a financial calculator or some Excel training.

Once you know the FCF apply the CAPM calculated with the unleveraged beta.

rue

Where:

rf= Risk-free rate of return for a theoretical investment without risk

rm= Expected market return

excessmarket = Excess market return

betaU = Unleveraged beta

Then adjust for debt and compare the differences with and without the debt shield.

As a Rule of Thumb for business valuation:

Debt Tax Shield = (Corporate Tax Rate)(Weighted Average Interest Rate) x (Total Debt)

Debt Tax Shield = APV without DTS x (Tax rate x Long-term Debt Rate)

What’s the difference?

The key difference is that the APV calculation uses the unleveraged equity discount rate (the discount rate that assumes that a company has no debt), rather than a leveraged (historical) discount rate that the WACC calculation uses.

If all those ratios make your head spin, check out this quick (1.5 hour) course on Financial Ratios. Of course the needs of multi-million dollar corporation are different than that of a small enterprise. So if you want to apply it to your own small business, I recommend learning about Lean Finance for Startups.

Multiples Method

Price-to-Earning Multiples: Also known as P/E ratios, Price-to-Earning Multiples compare a company’s market cap to its annual income. This is the most commonly used multiple. To ascertain the value of the company, its current equity value is divided by its recent net income to ascertain the price-to-earnings multiple.

EBITDA Multiples: EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization, and it’s a fancy way to say untaxed and un-adjusted profits. Once you have this amount calculated in a standard way, you can factor in the cost of outstanding debts to ascertain enterprise value and then also look at which multiples are used for other companies in the industry to determine equity value. As a multiples method, the total calculated enterprise value is divided EBITDA to determine the EBITDA multiple.

Earnings Multiples: Another method utilizes the earnings multiplier. This method is a good way to assign value to a stable and fairly predictable business that is about to make an IPO. It bases price value on multiples of the business’s earnings potential and so prospective buyers have the ability to translate the purchase price into expected earnings and projected return on investment (ROI).  It also has the distinct benefit of being a simpler basis to compare different businesses across industries and locations and also provides a more tangible and simpler basis by which to compare different businesses in different industries or locations. While relatively easy in practice, there are some challenges with this method. While earnings data is calculated from historical financials, the calculation needs the earnings to be precisely defined and calculated in the same way. Furthermore, you need to apply the right multiplier to earnings. Due to business risk, the multipliers can vary widely.

Comparable Transactions Method

Another type of valuation that relies to a certain extent on multiples is the comparable transactions methods. To use this method, you look at comparable transactions in that industry paralleled to a business with a similar model and then compare them by the relevant ratios and multiples such as Enterprise Value-to-EBITDA.

With the comparable transactions method, you are looking for a key factor that helps to determine the valuation. To do this you compare the financials of similar companies and try to find a multiple that closely predicts the valuation. Once you know that, you can use that multiple to value the company being considered.

Which Business Valuation Method Is Better?

Although there are many different business valuation methods available, for most businesses, a combination of these different business valuation methods will be necessary to set a fair selling price.