11 ways to value a company
A business valuation is a process used to estimate a company's or business unit's economic value. A valuation may be a precursor to a significant event, like a merger, acquisition, capital raise, or IPO. The business valuation process is the pathway to determining a sale value and tax reporting.
Knowing how a business is valued and which corporate valuation method best suits a given situation is critical for business leaders. This knowledge enables leaders to move forward and pursue a growth strategy, raise capital, sell a business, or undertake comprehensive strategic planning with confidence.
Key takeaways:
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Each business valuation type and calculation method provides an output that suits a particular business type at a particular stage of the company lifecycle.
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Income-based valuation may suit businesses with strong forecasting expertise and/or rapid growth.
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Market-based valuations suit companies in established industries where benchmarking is available.
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Asset-based valuation suits businesses that are asset-heavy, where the bulk of the business equity is in assets rather than service-provision, IP or human resources.
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The usefulness and accuracy of a valuation method will depend on the accuracy of the financial statements and financial forecasting that informs it.
Three corporate valuation types and which to choose
We’ll consider three types of corporate valuation, and both traditional and modern valuation processes within each type. Different company valuation methods suit different businesses and different stages of a company’s lifecycle.
Understanding what’s required for each and how the calculations are made helps you to select the right one for the business circumstances and industry. Grab the forecasting sheets, debt and equity metrics, P&L and financial analysis, and let’s get started.
Income-based valuation
Income-based valuations calculate the value of a company based on its anticipated future income or cash flows. To be accurate, the financial forecasting for a company must also be accurate.
Discounted cash flows
Discounted cash flow analysis estimates the value of a company or business unit based on the money it is expected to generate in the future. This calculation reflects the company’s ability to generate cash, a liquid asset, using a transactional financial formula. Discounted cash flow is considered to be the gold standard for intrinsic valuation.
Discounted Cash Flow = Terminal cash flow/ (1 + cost of capital) # of years in future
The limitation of this method is that it relies on the accuracy of the terminal cash flow value. Terminal cash flow can vary depending on the assumptions made about future growth and discount rates.
Discount rates reflect the risk and time value of money. This valuation method requires detailed financial projections and clearly articulated assumptions about growth and capital needs.
Capitalization of earnings
Valuation through a capitalization of earnings process is best suited for stable and mature companies with predictable earnings. Expected annual earnings are divided by a capitalization rate, the expected investor returns.
Business value = Future cash flow / capitalization rate
Income multiplier
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a commonly used example of an income multiplier.
EBITDA is a metric based on a company’s operational profitability based upon the core business operations, before the impact of financing costs, tax and non-cash accounting expenses like depreciation and amortization. The calculation may begin with net income or with operating income.
EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization
EBITDA allows comparison of profitability across companies and industries by neutralizing the differences in tax rates, capital structures and depreciation policies. This makes it useful as a proxy for operational cash flow, or as a snapshot of operational efficiency and profitability, before non-operating expenses.
Dividend discount model
For companies that regularly pay dividends, this model values the company according to the present value of expected future dividends, growing at a constant rate.
Earnings-based valuation
Company value can be determined as value relative to earnings capacity. Earnings multipliers aim to provide an accurate picture of the real value of a company, using profits rather than sales revenue as an indicator of financial success.
Future profits are adjusted against cash flow that could be invested at the current interest rate over the same period. In this way, the price to earnings (P/E) ratio (often stock price to earnings per share) is adjusted to account for current interest rates. A higher P/E ratio indicates that investors expect higher future growth from the company.
Market-based valuation
A market-based valuation determines the value of a company or business unit based upon its own value in the share market, or similar publicly traded or recently sold businesses. Recent market data establishes a benchmark, and key financial metrics are leveraged to derive a valuation.
This type of valuation is applicable to companies where there is sufficient market data. It’s less useful for niche or startup companies.
Comparable company analysis
Comparable company analysis (CCA) compares financial metrics of the target company with similar publicly traded companies to estimate the relative value, adjusting for differences in growth and market position.
Precedent transaction analysis
A valuation using a precedent transaction analysis considers recent acquisitions of comparable companies to inform valuation multiples. This valuation method can yield a higher valuation than comparable company analysis as it incorporates control premiums, the additional amounts buyers pay to acquire controlling interests.
Precedent transaction analysis should include careful adjustment where market conditions varied from current market conditions.
Market capitalization
Suitable for publicly traded companies, market cap (stock price x outstanding shares) provides a straightforward and quick equity valuation. Note that this does not account for debts and liabilities of the company.
Enterprise Value to EBITDA
Enterprise Value to EBITDA is a ratio that indicates how much investors pay for operating earnings before financing and non-cash expenses. A low ratio indicates that the business may be undervalued while a high ratio indicates the business may be overvalued.
Enterprise value is the sum of the company’s market capitalization and debts, minus cash or cash equivalents on hand.
Enterprise Value = Debt + Equity - Cash
Asset-based valuation
Asset-based valuation essentially subtracts the liabilities from the total assets of a company at a given point in time.
Asset-based valuation is best suited for asset-heavy companies in industries like manufacturing, real estate or retail. This valuation process is less applicable for service businesses or tech startups with fewer tangible assets.
Book value
The simplest way to assess the value of a business is to subtract liabilities from assets. This method, known as the “book value”, often doesn’t represent the true picture of a business’s financial health and potential.
Liquidation value
The liquidation value of a company estimates the net cash after assets are sold and debts paid.
Replacement cost
This valuation method values the business according to the cost to replace its assets.
When a more comprehensive method is required to capture and represent the value of a company, it’s worth considering market-based and income-based valuation processes above.
Limitations of metric-driven company valuation methods
Business valuation formulas like those explored here have inherent limitations. These limitations may be where the calculations rely on subjective judgements, the accuracy of the input data, or where past financial performance is used to predict future performance.
A valuation formula may not capture less quantifiable metrics like the impact of sustainability policies on the business valuation, the leadership quality, competitive advantages, or synergies that could arise during merger or acquisition integration.
Be prepared for a material event with a platform that brings order to the chaos of business operations
Knowing the valuation of your company can enable strategic decision-making in the face of a material event. Preparation is key for capturing the optimal value of a business when selling a business, raising capital or spinning off a business unit.
Leave nothing to chance — it’s never too early to start preparing and organizing key documentation into the structures that will hasten the due diligence process. With Ansarada’s Deals Platform, you can get started for free, and benefit from proven informational structures developed using data from thousands of transactions.
Corporate valuation FAQ
What is the rule of 40 for a SAAS company valuation?
The rule of 40 is a principle that states that a software company’s combined revenue growth and profit margin should equal or exceed 40%. SaaS companies above 40% generate profit at a sustainable rate, while those below 40% may face cash flow or liquidity issues.
How to value a private company?
A private company valuation may follow the Discounted Cash Flow process, or a Comparable Company Analysis, taking into account financial performance, growth opportunities, industry trends and risks.
The information provided in this article is for informational purposes only, and does not take into account any local laws or specific business circumstances. Seek expert financial advice when undertaking a company valuation regarding the best method for your business situation and goals.
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