When it comes to the method of calculating a company valuation, there are several routes you could go. They vary based on specific company circumstances and what your rationale is for obtaining the valuation. Arriving at an accurate company valuation isn’t always the simplest process in the world, but it is incredibly important to assessing the fair market value of your business—especially if you are planning to sell and want to get the highest possible price.
Even if you choose to hire a professional to help you with your valuation, it is helpful to understand the many valuation processes. By knowing your options, you can decide what is best for your company based on its distinct situation, as one approach may be more beneficial than another. The most common types of business valuations are explained here for your easy reference.
The EBITDA or earnings multiplier method is often used to get an accurate understanding of the real value of a business because it focuses heavily on profits. Under this process, the current price-to-earnings (P/E) ratio is adjusted to account for current interest rates. So, future profits are adjusted against cash flow that could be invested at the current interest rate over a similar period of time.
Times Revenue Multiplier, or Profit Multiplier
This manner of valuation takes a stream of revenues generated over a certain period of time and applies it to a multiplier that is based on the current industry and economic environment. Typically, a higher multiple will be used if the business is bigger and has a quality track record. Small businesses tend to command a P/E multiple of between three and four using pretax profit, which can go up to as high as five if it is a proven high performer. For larger businesses, multiples can range from seven to twelve.
When valuating a company using P/E multiples, the adjusted profit based on owner’s salary should be accounted for to ensure the company’s value once the owner exits. Something else to consider when using P/E multiples for valuation is the average profit or Earnings Before Interest and Tax (EBIT). This allows you to gauge your actual profit position before debts or surplus cash balances change it.
This tactic assesses your company’s total net asset value and subtracts the value of its total liabilities according to its balance sheet. There are two ways to make this assessment:
- Book Value: This method is based on the value of shareholders’ equity of a company as shown on the balance sheet statement. The value is calculated by subtracting the total liabilities of the business from its total assets.
- Liquidation Value: The purpose of this asset-based approach is to determine how much net cash would be remaining once all assets are liquidated and liabilities paid. Because liquidation valuation does not treat the business as viable, the assessment does not include intangible assets. When a business is assessed using a liquidation valuation, the assets sell for a lower value than market value. Because this process is usually used in an urgent situation, the seller’s objective is often to get the most money in the shortest possible time period.
Discounted Cash Flow (DCF)
The DCF valuation method is similar to the earnings multiplier. It based on projections of future cash flows that are adjusted to calculate the current market value of the business. The primary difference between the DCF and the profit multiplier methods is that inflation is taken into consideration to arrive at the present value. The DCF process can be helpful in the case that your profits are not forecast to maintain consistency in the future.
Comparable Company Analysis (CCA), or Comparative Market Analysis
CCA values a company by using the metrics of other similar companies as far as size and sector, assuming that these similar companies have similar valuation multiples that can be compared.
A business’s valuation ratio dictates whether it is overvalued or undervalued. A high ratio means it is overvalued, and a low ratio means it is undervalued. The most common valuation ratio measurements used in CCA are:
- Enterprise value to sales (EV/S)
- Price to earnings (P/E)
- Price to book (P/B)
- Price to sales (P/S)
Market Cap might be simplest method of business valuation because it is based on publicly traded stock. It is calculated by multiplying the company’s share price by the total number of shares outstanding.
Market capitalization is not the same as market value, even though the terms are often confused and used interchangeably. Market value is a much more complex method of determination because there is much more to consider than shareholder equity, and many factors assessed are variable such as multiples, EBITDA, P/E ratios, and supply and demand.
This valuation method examines the operating assets of a company and assigns value based on what it would cost to replace those assets.
Under this approach, the current state of technology in the industry is important because certain innovations may offer more efficient ways to achieve the purpose of the business’s assets. Obviously, this is more common in tech-based companies since technology evolves quickly. It can cause the book value of the assets to differ greatly from their actual value. The value of each asset is seen independently of the overall operations of the business and each is added together to arrive at a valuation.
Breakup Value, or Sum-of-Parts Value
The breakup value of a company looks at the individual value of each of its distinct core business segments if they were separated into their own entities. If the breakup value turns out to be more than its market cap value, investors may call for divisions to be spun off, and investors receive cash or stock in the newly formed companies.
Valuations Are Important—Selling or Not
Even if you are not planning on selling your company, getting an accurate company valuation can be a helpful tool for a slew of reasons.
- It’s a great way to set a baseline for your business so that you can plan for the future and create a framework for the ways that you can make any needed improvements.
- It can also help you monitor your progress in achieving these goals, and identify gaps in your business’s performance.
In any case, valuations shouldn’t be viewed solely as a necessity for exiting or selling a company. They can provide significant advantages for the overall health and operations of a business at any stage in the game.