What are the Most Common Methods for Valuing a Company?

Determining a company's worth is a critical process for selling a business, attracting investment, or strategic planning. The most common company valuation methods include asset-based approaches, income approaches like discounted cash flow, and market-based comparisons. The optimal method depends on your company's industry, size, and the specific purpose of the valuation. This guide breaks down the primary techniques used by financial professionals.

What is the Purpose of a Business Valuation?

A company valuation is a formal process to assess the economic value of a business. This calculation is essential not only for potential sales or mergers but also for securing investment, establishing partner ownership percentages, and strategic planning. According to industry standards, a thorough valuation examines tangible and intangible assets, revenue streams, market position, and future earnings potential. Common triggers for a valuation include:

• Preparing for a sale or acquisition.
• Seeking investment or issuing shares.
• Succession planning or transferring ownership.
• Legal requirements, such as divorce proceedings or tax assessments.

How Do You Value a Company Based on its Assets?

The asset-based approach calculates a company's value by subtracting total liabilities from total assets, a figure often referred to as net asset value (NAV) or book value. This method is straightforward and is often used for asset-heavy businesses. There are two primary ways to apply this approach:

1. Going Concern Value: This method assumes the company will remain in operation. It values assets based on their current use, not their immediate liquidation value.
2. Liquidation Value: This method estimates the net cash received if all assets were sold and liabilities paid off, typically used for companies facing closure. This value is often lower than the going concern value.

What is the Income Approach to Valuation?

The income approach values a business based on its ability to generate wealth in the future. This is a core method for valuing companies with strong growth potential. The most common technique is the Discounted Cash Flow (DCF) analysis.

A DCF analysis projects the company's future cash flows and then "discounts" them back to their present value using a discount rate (often the weighted average cost of capital). This discount rate accounts for the time value of money and the risk associated with the investment. This method is highly dependent on the accuracy of future growth projections.

How Does Market Capitalisation Value a Company?

For publicly traded companies, market capitalisation is a simple and effective valuation metric. It is calculated by multiplying the company's current share price by the total number of outstanding shares. This figure represents the market's collective valuation of the company at a given point in time. For example, a company with a share price of $50 and 10 million outstanding shares has a market cap of $500 million.

When Should You Use the Market-Based Approach?

The market-based approach values a company by comparing it to similar businesses that have recently been sold or are publicly traded. This involves using valuation multiples, such as the price-to-earnings (P/E) ratio or enterprise-value-to-sales (EV/Sales) ratio.

For instance, if comparable companies in your industry sell for an average of 6 times their annual earnings, and your company's earnings are $1 million, the estimated value would be around $6 million. The challenge with this method is finding truly comparable companies with accessible and reliable financial data.

Key Takeaways for a Credible Valuation

Based on our assessment experience, a credible company valuation often involves using more than one method to establish a realistic value range. Relying on a single approach can lead to significant over- or under-valuation.

• Define the purpose of your valuation first, as it will influence the most appropriate method.
• Consider engaging a professional valuator, such as a certified financial analyst, for high-stakes situations like a sale.
• Use a combination of methods to triangulate a fair market value and support your findings with solid data.

Ultimately, a well-researched valuation provides a powerful foundation for informed business decisions, whether you are buying, selling, or planning for the future.