How to Calculate the Valuation of a Company

Whether you’re looking to buy a business or sell your startup, you have to determine a price for it. There are several different ways you can determine the valuation of a company, including the worth of the assets, the valuation of similar businesses and the size of the projected future cash flow. Even if you hire someone to appraise the company and arrive at the valuation of the business, it’s important to understand the methods they use.

Why Valuation Matters

Calculating the worth of a business is essential if you’re buying or selling, but that’s not the only reason.

  • If you’re looking for financing, lenders, investment bankers and venture capitalists will want to know what company’s worth.
  • If you’re in a partnership and one partner wants out, you need to calculate the value of that partner’s share of the company.
  • In a divorce, a valuation of the business may be required so you can divide up marital assets equitably. 

Valuation of a company can be contentious. In the partnership scenario, for example, your partner may want a higher value for his stake than you think his share is worth. That’s why objective valuation methods are useful.

Valuation of Business by Stock Price

When a company is publicly traded, it’s relatively simple to come up with a market value using the stock price. Say the company has 500,000 publicly traded shares, and they’re currently selling at $20 each. At that price, the worth of the total shares is $10 million.

This is the simplest way to set a price, but it’s not the best. The share price is based on the perceived value of the company, which may not reflect the actual worth. The subjective side of stock prices is one reason they fluctuate. Using stock price solely for valuation is risky because:

  • Investors may base the share price on the anticipated success of a soon-to-launch new product. When the product debuts, it could flatline, and shares plummet.
  • The investors buying up the stock may not have made a serious valuation of the business.
  • Investors may anticipate future growth that doesn’t happen.
  • Investors may assume that because the company grew last year, it will grow as much in the coming year. That doesn’t always happen.
  • The stock price may be a response to temporary lousy news that doesn’t reflect the company’s underlying value. 
  • If the company isn’t heavily traded, the share price may not mean much.

Of course, if your company isn’t publicly traded, and most small businesses aren’t, you need to use a different method to establish the company’s value.

Valuation of a Company by Comps

Another method for setting a price is to compare one company to a similar one. If you’re selling your business, for example, you can look for companies in your geographic area in the same industry and extrapolate your value from theirs.

One way to acquire these “comps” is to look for businesses that have sold recently and find out their sale price. Another is to pick a metric such as the price/earnings ratio, if the information is available.

Using comps has its limits, though:

  • You may not be able to find comparable sales.
  • If the sale data isn’t recent, it may not reflect the current market value.
  • Few comps are identical. Figuring out how to adjust the formula to reflect key differences, such as one company having aging equipment or better-trained staff, may be tricky. 

Valuing the Assets

An asset-based appraisal is a method that doesn’t require complicated math. Add up the value of your assets, subtract your liabilities, and you have the total value of your business. There are two approaches you can use:

  • Going concern. This approach assumes the business stays up and running and that you won’t be selling off major assets.
  • Liquidation. This approach bases the valuation of the business on what you’d get if you closed it, sold the assets, and paid off your debts. This gives you a lowball valuation because liquidation sales don’t usually bring the market price. 

The drawback to an asset-based valuation is that a good business is worth more than the value of the equipment, real estate, inventory and other assets.

Discounted Cash Flow Valuation

Discounted Cash Flow (DCF) is a much more effective method for establishing a company’s value. Valuation of a company by DCF requires more number-crunching than asset appraisal. However, considering how much cash a business will generate in the future provides a much better view of the company’s real worth.

The reason for basing the valuation of the business on cash is that ultimately, cash is what owners want and need. If your company’s income is fabulous, but your cash flow is negative, you can’t pay the bills, the landlord or your employees.

How to Calculate DCF

  1. Calculate your future revenue. You can base this on a simple growth forecast or consider factors such as price, volume, competition and your customer base. The second option takes more work.
  2. Project your expenses and your capital assets. Combined with revenue, this lets you determine your future cash flow.
  3. Figure the cash flow’s terminal value. For example, what will the total value of future cash flows be after five years?
  4. Finally, use the terminal value to figure out the net present value based on standard formulas. If the company’s cash flow yields $17.5 million in terminal value, that amount isn’t something you can tap in the present to pay bills. You discount the cash flow to derive the value of future money in the here and now. That gives you a dollar figure you can set as the worth of the company. 

Advantages of DCF

DCF valuation has many advantages as a tool for the valuation of a company.

  • It doesn’t require comps.
  • You can incorporate your assumptions and expectations about the future of the company into a DCF calculation.
  • You can use DCF with multiple scenarios as to how the future plays out.
  • While it takes a lot of math, you can use Excel to simplify some of that.

Disadvantages of DCF

However, using DCF valuation does have some drawbacks.

  • You use assumptions about future growth and cash flow. It’s tempting to make them overly optimistic.
  • Changing your assumptions can create radically different future cash flows.
  • Figuring DCF is a complex approach so that errors can creep in.
  • With Excel, it’s easy to make a DCF calculation. Making an accurate DCF calculation, however, takes skill and experience on top of that.

The Cost of a Startup

Another method, though not widely used, is the valuation of a company based on what it would cost to start the same business from scratch. If you’re looking at buying a manufacturing firm, for example, you would calculate what it would cost you to buy the equipment, lease the necessary space, purchase vehicles and hire a trained workforce. This gives you one way to measure the worth of an established company.

The drawback to this approach is that, like asset-based valuation, it doesn’t consider the company’s future earnings or cash flow.

Multiply the Revenue

As with cash flow, revenue gives you a measure of how much money the business will bring in. The times revenue method uses that for the valuation of the company. Take current annual revenues, multiply them by a figure such as 0.5 or 1.3, and you have the company’s value.

You don’t get to pick your multiplier. They’re specific to the industry: 2.56 for household products and 1.39 for food processing, for example. Applying the times revenue method to a company with $360,000 in revenue generates a value of $500,400 in the food-processing industry but $921,600 in household products.

Rather than use the times revenue method by itself, business analysts may use it to set an upper limit on the value of the company.

Surplus and Debt

Once you derive the valuation of a company, you may need to tinker with it. Most methods don’t worry about the cash on hand or how the total of the company’s debt. You should take that into account before setting a final price.

For example, suppose you want to sell your business, and the discounted cash flow method gives it a net value of $560,000. However, you have outstanding loans of $200,000. If the debts come with the company, the buyer may not be willing to pay more than $360,000.

If you have more cash on hand than you need for immediate expenses, you might want to raise the price of your business to reflect the cash surplus. Alternatively, you might work out a way to leave with the surplus and let the buyer keep everything else.

Bring in a Professional

When it’s time to make a valuation of a company, you may be better off if you don’t fly solo. Even if you’re good with finance and spreadsheets, valuation is a specialized skill set. A professional appraiser knows the right multipliers to use, the recent comps, the dynamics of the market and how to apply them to your unique business.

Equally important, professionals are objective. Whether you’re looking at an exit strategy or preparing to buy your dream company, the skin you have in the game can cloud your judgment. Having a coldblooded professional assessment can steer you away from making a mistake.

A realistic valuation also speeds up the process. The appraiser knows how to price a company to sell in the current market environment.

Choosing the Valuation Method

Even within one method, such as the DCF valuation of a company, changing your assumptions can create a wide range of valuations. With multiple methods, the results are all over the map. An asset-based valuation may produce different results from calculating net cash value. Comps may show businesses like yours are selling for more than the numbers you crunched in Excel does.

If you’re selling, you want to use a method that gives you the best price while staying realistic. If you’re buying, you want the price as low as possible without the seller saying no. Beyond that, there’s no exact science that says which alternative is the right one, so how do you decide?

  • Ask yourself why you need a valuation. If you’re weighing the pros and cons of buying a company, you need to know if the purchase is profitable. If you’re looking at closing your doors and selling everything off, your needs are different.
  • Are you an asset-heavy company? If your business owns a lot of valuable property such as land or important patents, the book value of the assets might be more than the discounted cash flow or times revenue method says you’re worth.
  • What’s the norm for your industry? It makes sense for manufacturers with lots of equipment to make an asset-based valuation. If you’re providing professional services and use next to no equipment, assets are irrelevant.

If you’re willing to put in the energy, there’s no reason you can’t try several methods to see what range of values result. This is standard for investment bankers: Check comparable companies and recent sales and then run a discounted cash flow analysis. Looking at the average of all three methods gives investors an idea of how much money they’re comfortable putting into your business.