Not only do owners and executives of privately held businesses often wonder about how to determine a company’s value, but they also have lots of other questions, like what they can do to improve the value of their business.
So, how do you evaluate a company’s worth? Determining the value of a business can be broken down into four common methodologies for systematically deriving worth. Let’s have a look at each.
How to determine a company’s value:
1. Book Value
Book value is one of the simplest and often considered least accurate ways to evaluate a company among the valuation methods. The book value of a company is the total value of the company’s assets minus the total of its liabilities. This is an important number because it gives investors an idea of what the company is worth if it were to be sold today.
2. Publicly Traded Comparables
The public stock markets assess the valuation of every company’s traded shares. This provides a basis for determining a company’s value, particularly when compared to companies similar to yours. This method usually looks at the last twelve months (commonly referred to as LTM) and next twelve months (NTM) of revenue and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
A valuation expert would input your company’s performance and projected performance next to the average multiples in each category and develop an estimated value in each category. Then, the expert would determine a weighted average for the four different estimates and arrive at a valuation of between $8 and $10.8 million for this method.
3. Transaction Comparables
The next approach to figure out the value of your business follows a process similar to the publicly-traded comparable example above; only the focus is on recent transactions. Transaction comparables are used in determining a company’s value in a variety of ways. They can be used to value a business by looking at similar transactions that have taken place in the past. This information can be used to evaluate a company by looking at factors such as the price-to-earnings ratio, the price-to-sales ratio, and the price-to-cash flow ratio. Transaction comparables can also be used to value a business by looking at the market value of the business’s assets.
4. Discounted Cash Flow
While the first three methods for determining a company’s value focus mostly or entirely on historical performance, the discounted cash-flow method is almost solely driven by the projected performance of the firm into the long-term. This method derives the cash flow the company will produce into perpetuity, if applicable. It then discounts those cash flows back into today’s dollars (also referred to as net present value (NPV)). Let’s assume this method finds an estimated value of $11 million.
Cash flow is the single most significant determinant of the value of your business. It’s also simple to grasp: How much cash have you generated, and how much will you generate in the future? The more consistent and predictable your cash flows are in your business model, the higher the value of your business.
With four different estimated values, a weight is applied to each to come up with the overall estimated value. The weight assigned to each cash flow depends on when it is expected to occur. For example, a business that is expected to generate $100,000 in cash flow next year would be given a higher weight than a business that is expected to generate $50,000 in cash flow in five years.
Once the weighted valuation is derived, some other discounting factors may exist. Since the securities of privately held businesses do not have a liquid and active market in which to trade, a discount is often applied to the valuation to trương mục for this, minority interest positions, and other factors.
Several additional subjective elements can affect business valuation, but those are worthy of an article of their own. Nevertheless, with these general guidelines, you should be able to understand how to figure out the value of your business and come up with an “envelope calculation.” For anything more serious, you should consult a valuation expert who can apply these and other relevant principles to the valuation of your business in much finer detail.
A version of this article was originally published on May 18, 2011.
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