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How to assess the value of a company?

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For every entrepreneur, his business is like "his child" and therefore invaluable. However, when selling a business, its value must be converted into real numbers. In order to achieve a specific result, various methods have been developed by which the value of a company is assessed. This article introduces a few of the most common possible methods for valuing a company.

Asset-based method

The asset-based approach is based on the replacement value of the company's assets. This method is based on the assumption that the potential buyer of the business is not willing to pay more for the business than it would be to replace the company's assets.

This method calculates the value of a company by deducting its liabilities from the market value of its assets.

Example. The assets of the small producer are production equipment worth €20,000 and a loan to the bank of €5,000. Subtracting liabilities from assets (€20,000 - €5,000) gives the value of the company at €15,000. This means that, as an alternative to buying a business, a potential buyer could start a new business for €15,000 by borrowing €5,000 from a bank to buy similar production equipment for €20,000.

The value-based approach is simple, but does not take into account the company's added value or ability to generate money in the future. This is why the value of a company found in the asset-based method is usually the lowest compared to other methods.

However, in certain situations, it is worth considering an asset-based approach. This is the case, for example, when the business to be sold is no longer economically active or is about to close.

This approach also makes sense if the value obtained by other methods is significantly lower. This may occur, for example, when the net asset value significantly exceeds the value of future revenue.

Discounted cash flow method

The discounted cash flow method is in practice one of the most widely used methods for valuing a company (and also other investments). This method determines the value of a company according to its ability to generate future cash flows.

In other words, the more a company can make money in the future, the more valuable it is today.

When applying the discounted cash flow method, cash flows are first estimated for subsequent years (the next 5 years is most commonly used in practice). On top of that, a terminal year is added, which reflects the company's cash flows after the forecast period until infinity. Free cash flows for the company/firm (FCFF) are calculated for each year of the forecast period.

FCFF=(EBITDA-∆NWC-CAPEX)×(1-TAX),

where EBITDA is earnings before interest, taxes, depreciation and amortization, ∆NWC change in net working capital, CAPEX investments in fixed assets and TAX income tax rate.

However, as the value of money decreases over time, cash flows must also be discounted to present value. The discount rate used is the weighted average cost of capital (WACC), which is the rate of return that a company is expected to pay on average to all its financiers (both shareholders and creditors).

Finally, in order to find the value of equity, it is necessary to subtract the company's net debt from the result and add free cash. The value obtained is the amount that the owner could receive from the sale of the business.

Although the discounted cash flow method looks like a strict mathematical formula compared to other methods, there is also considerable subjectivity in it. First, cash flow projections are seldom accurate, especially over longer periods. The result is also significantly affected by the time value assigned to the money, which is reflected in the discount rate.

Comparison method

In the comparison method, the value of a company is determined on the basis of other similar companies whose value is already known.

This means finding companies whose size, product range, location and other characteristics are as close as possible to the company being assessed. This ensures that the values ​​of comparable companies are similar.

The comparison method often uses ratios, the most common of which are P/E, P/B, P/S, EV/sales and EV/EBITDA. If we know the ratio of the company being compared and the indicator chosen by the company being evaluated, we can calculate the value of the company. The net debt must also be deducted from the value of the company found in order to reach the value of equity.

Example. The EV/EBITDA ratio of the comparable company is 8. The EBITDA of the evaluated company is €100,000. Multiplying this ratio by 8, we get the value of the company being valued at €800,000. If the amount of net debt is, for example, €200,000, we get an equity value of €600,000.

As the benchmarking method is largely a generalization, different parties may arrive at different results when evaluating a company. Therefore, it is particularly reasonable to apply this method when there are a sufficient number of similar companies for which the necessary data are also available from public sources. Therefore, this method may not be very suitable for smaller companies.

EBITDA multiplier

The EBITDA (earnings before interest, taxes, depreciation and amortization) multiplier is a trivial but arguably simplest method of valuing a company, both from the buyer's and the seller's point of view. The method is to multiply a company's EBITDA by a number, usually between 5 and 15.

For example, multiplying EBITDA by 5 means that if an investor bought at that price and the company operated in the same way in the following years, the return on investment would be 20% without taking into account the increase in the value of the company and the final value of the company. This makes this method well understood and appreciated by the potential buyer, which is the reason for the popularity of this model.

The EBITDA multiplier method is only suitable if EBITDA has remained stable in recent years and no significant changes are expected in the future. When choosing a multiplier, a higher number can be used if it is a very stable area or revenue (eg roads, routes, routes, etc.). The lowest multiplier must be agreed if the stability is lower or the sale of the company is fast.

Although there are many different methods for estimating the value of a company, none of them is 100% accurate. In practice, many additional factors have to be taken into account which affect the final sales price.

These can be, for example, a well-known brand, the current state of the economy, competition, etc. (see also: Factors affecting the value of a company). Therefore, in order to achieve the most comprehensive result possible, it is also necessary to rely on knowledge and experience, which can be assisted by professional counselors.

Kadri Lenk
Kadri Lenk
kadri.lenk@incorply.ee

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