How to value a business? Methods, Steps and Advise
The valuation of a company is often a delicate exercise. It is not enough to consider past financial flows in the balance sheets. To do this various calculation methods exist, the relevance and accuracy of which depend above all on the sector of activity. With the help of financial experts, the seller or buyer will be able to determine an appropriate price range taking into account expected future results.
However, the valuation of a company is never an exact science and the final price will be, above all, the result of negotiations between the seller and the buyer.
Why value a company?
The real value of a company is not only the book value of its assets and liabilities. Determining the real value of the company is essential in the context of a business sale or transfer. The seller and the buyer have at their disposal different valuation methods, as well as experts (accountants, M&A consultants…) to determine a value as close as possible to the market value. This step is particularly important in negotiations, to conduct discussions based on objective criteria.
What are the main criteria for valuing your company?
In addition to purely accounting data (EBITDA, cash flow, operating income, etc.) the company also has an intangible value, a concept similar to that of goodwill. Its reputation, the quality of its organisation, the training of its personnel, the loyalty of its customers, its positioning relative to the competition in the reference market, are all elements that must be taken into account when selling or acquiring a company.
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What are the calculations and methods for estimating the value of a company?
Here we will look at the three main methods of valuing a company:
- Valuation of assets
- Valuation by comparison
- and by future financial flows.
Valuation of assets
The asset valuation consists of valuing the company based on its assets. This evaluation is done by consulting the balance sheet which details the company’s assets (what the company owns) and the liabilities (how it has financed it). Using this method, the equity value of the company is calculated by subtracting the debt from the total assets. This gives us the net book value or net position.
However, this method has its limitations as it does not take into account the possible evolution of the value of fixed assets: the value must therefore be adjusted for unrealised gains or losses based on market trajectory. It also does not include the goodwill of the company (or bad will, or a negative netbook valuation), which is the difference between the market value and the net book value. In short, the analysis is static and does not easily integrate potentially important changes in the company’s profitability.
This formula, which provides an overview of the company’s assets, is rarely used on its own and must be supplemented by other approaches to refine the valuation of the company.
Valuation by comparison
A second method that can be used is that of comparison. It consists of identifying comparable companies with similar characteristics. This sample is called a ‘peer group’.
A few example characteristics:
- industry sector;
- products and services;
- geographical area;
- size and maturity;
- competitive position;
- growth rate;
- financial structure;
Then financial indicators are established to compare the company to be valued with the peer group. Generally, this is EBITDA, or EBIT (or more rarely sales).
Analysis of comparable transactions makes it possible to determine a ratio between the indicator calculated and the value of the companies sold within the same peer group. This ratio is then applied to the business being sold. This method is interesting because it makes it possible to determine a value that is consistent with the market. However it is difficult to identify a sufficient number of transactions in the market for these to be comparable.
The valuation of a company using the discounted cash flow method
A third, more technical method is the discounted cash flow method (DCF). This method implies being able to project the company’s future results and to estimate a discount rate. It is recommended to estimate discounted cash flow over a long-term horizon (between 5 and 7 years). The discount rate for discounted cash flows is usually the weighted average cost of capital.
The advantage of this method is that it takes into account the company’s prospects. The limitation is that it is based on uncertain flows that are difficult to identify over time.
What are the pitfalls to avoid when estimating the value of a business?
For the seller of a company, it is important to have a realistic and justifiable valuation. This is why it is necessary to be accompanied by financial experts who can indicate how to best value the company, potentially by combining several calculations in order to give the most reasoned view possible of the proposed value.
How to best value your company?
A complete diagnosis of the specific elements that influence the value of the company must be carried out in order to obtain an overall and fair vision of its value.
Here is a non-exhaustive list of items to consider:
- The company’s place in the market and the value of the market;
- The company’s skills and expertise;
- The internal and external environment of the company;
- Human capital;
- Social climate;
- Customer quality;
- Financial structure;
- Financial potential;
In the context of a sale presenting a long-term strategic plan and solid, objectively justifiable prospects for return will strengthen the seller’s negotiation position.
To conclude, evaluating a company requires technical accounting and financial skills. It is therefore recommended to call upon a professional (chartered accountant, expert in conveyance, specialists in the transfer or valuation of companies, …).