18 Sep How to Determine the Economic Value of a Company
Your company is your major asset; therefore, you need to know its value. Think of company valuation as a subjective science. The subjective element is that every purchaser’s considerations and situations vary, so two buyers may give you two different offers. The science part, on the other hand, is that you need to employ standard methods of company valuation.
There are several methods of company valuation used to work out the fair value of an organization for different reasons, including mergers and acquisitions, divorce proceedings, and establishing partner ownership. Often, business owners hire professional valuation firms for an objective estimation of their business’ value.
The valuation process covers a wide range of methods and fields, which can vary between industries, businesses, and valuators. Under each method, you may employ different techniques. However, no fixed formulas or rules apply to determine how much your company is worth. Still, we are going to show you the most used methods of company valuation.
Common methods of company valuation include:
• Income/Profit Multiplier Approach
This method involves valuation techniques that convert projected financial returns, for example, cash flow, into a single amount. Depending on the method you employ, income might indicate pre-tax profits or after-tax profits. It also can indicate earnings before taxes and interest, or any other cash flow measure. Under this approach, however, the two most commonly used techniques are the multiplying period capitalization technique and the single period capitalization approach.
For example, if your company’s net profit is $200,000 per year, and you use 5 as the multiple, then you calculate your company’s value as 5 x $200,000 = $1,000,000. From the buyer’s perspective, provided the business continues to realize the same annual profits, they will earn $200,000 per year for the $1,000,000 investment, which is a 20% return.
• Market Approach / Comparables
With this valuation method, you use transactional data to determine your company’s value. This method involve public company transactions, public company valuations using up-to-date stock market information, as well as private company transactions. The idea behind this approach is that valuation processes of businesses that have been acquired in arms-length deals should give you a good idea of how much your business is worth.
• Discounted Cash Flow Method
This approach is similar to the income approach; however, the main difference between the two is that it makes an allowance for inflation to calculate the present value of a company. For example, say that someone is offering you $10,000 now, or $1,000 per year for the next 12 years. The latter option may seem like the better offer, but you need to account for inflation.
Assume an inflation rate of 5%, so the $1,000 you are going to earn next year is worth roughly $950 today. However, if you take the $10,000 today, then you can invest the amount in something that will give you a good return every year.
• Asset Valuation Approach
This approach views your business as a set of assets that are used to measure the value of your business. Since your business has tangible and intangible assets, use the market value to measure the value of your company. Essentially, add up all the equipment, cash, stocks, inventory, patents, real estate and goodwill while calculating the asset valuation.
Often, this approach serves as a foundation for valuation since most businesses are worth more as a going concern than they would if shut down. This is because the present value of future income generated by the assets typically exceeds the liquidation income of those assets.
• Future Maintainable Earnings Approach
Your company’s future profitability determines its present value. Use this approach to value your business if you expect the profits to remain stable. To use this valuation method, evaluate your company’s sales, profits, expenses, and gross profit from the past three years. This information helps you predict the future and value your business today.
You need to have an up-to-date business valuation if you want to sell your business or acquire equity or debt financing for expansion. Potential investors or financiers will need to know that your company has sufficient worth. You may also be adding shareholders. In this case, you need to determine your company’s share value.