How to value a business?

How to value a business?

Company valuation is more an art than exact science. Value itself depends on lot of subjective factors and is not easily calculated. It is reasonable to use several approaches and to calculate the range of values by using different scenarios. And it is wise to roughly project where the company will be 5 to 10 years from now and what is the probability of your estimations. I personally use the asset valuation approach as it is rat
her impossible to estimate future cash flows, and the asset values change less. So very briefly these are the 4 most used methods.

1. DCF approach

Value of a company is the sum of all cash flows that it will be generated during its lifetime. By estimating future cash flows and discounting it back to the present time it is one possibility to calculate the current value of a company. DCF model is very flexible and there are several inputs that will change the outcome a lot. And future itself is uncertain, so forecasting the future cash flows contains risk that the analyst may be wrong. So it is usual that two analysts analyzing the same company can reach different values. As said the DCF model is highly dependent on input variables: cash flows and discount rates that can cause high variation of results. Therefore DCF is suitable for analyzing mature companies with stable and predictable cash flows, or where the future cash flows. High growth companies or startups are hard to value using DCF, as their revenues, earnings or margins are uncertain.

2. Asset value approach

This method analyses the asset values on the company balance sheet in order to determine their market value. After you subtracting liabilities from assets the remaining is the book value of the business. By dividing the book value with total company shares we get the per share value that can be easily compared with the market price. In order to understand whether the company is under or overvalued the Price to Book ratio is used. Company book value is undervalued if the book value per share is below 1 and is overvalued if it is above 1. This method is favored by lot of well-known value investors and usually those that are contrarians and turnaround investors. This method is also linked to liquidation method which means that is if the company is closed tomorrow what would be worth its equity. By using stock screeners the companies trading below book value can be found. It I emphasize here that there is a certain reason why some companies are undervalued in terms of their assets. It is because of the problems in industry, the company specific problems or the assets are not worth what the value is in balance sheets. Father of value investing Mr. Benjamin Graham used to buy stocks that had market caps lower than their working capital (called net nets). Nowadays these are extremely hard to find.

3. Using multiples

It is simplified approach and should be used with a reservation. One needs to make more deep analysis in order to assign exact value of the business. Most popular ratios are Price to earnings, Price to sales, price to book, PEG Ratio, Dividend Yield or EV/EBITDA are some of the most common multiples. Analyst needs to look other factors also, quality of earnings, growth of the business and industry characteristics. If company is trading with P/E of 10, it does not imply it is a bargain. In case we figure out that the earnings will decline in the future, this P/E is relatively high and the business may be overvalued. But if earnings are estimated to grow +20% in next 5 years, the company trading at 10 P/E is relatively cheap. But earnings can be manipulated…

4. Transaction value

Companies can be analyzed by comparing them with the peers. So you should look at recent acquisitions of similar companies in the same industry. For example if the acquirer is ready to pay 6–8 times EBITDA for companies in a certain industry this is a rough guide what are the remaining companies with similar characteristics worth.

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by A.R.

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