What is a company worth? - 5 ways to value companies

Are you buying shares in a company, or perhaps selling existing shares? Then you need to know what is a fair price. In this article, we look at different ways of carrying out a company valuation.

The methods we review can be used to value businesses, whether they are unlisted companies or listed:

• In the case of unlisted shares a business valuation may be needed for a buyer and seller to agree on a price at all. It is also common in the event of a division of property, estate settlement and court disputes.
• For listed shares a valuation can be made to assess whether the market is overvaluing or undervaluing the stock.

Different methods for valuing companies

There are several established methods for valuing companies:

• Relative valuation - value based on what similar company sold for 
• Substance valuation - is based on the net value of assets and liabilities
• Yield valuation - value based on historical profit via a profit multiple
• Cash flow valuation - valuation based on estimated future cash flows
• Liquidation valuation - when the company is to be closed down

We will go through each of these different types of business valuation in a moment.

Valuing yourself or hiring an expert?

Do you mostly just want satisfy curiosity you can value a company yourself, at least with a simple variant of net asset value or income valuation.

But if you are buying or selling shares (or even an entire company), or if the valuation is done in connection with a divorce and division of property, a dispute in court or similar, then you should definitely carry out a professional business valuation.

On the one hand a good appraiser knows how assets and profits should be normalized for the calculation itself to be correct. That is, adjust for market value or things that are not representative of the business. On the other hand, the valuation itself is given a weight that can gain the respect of your counterpart or get a hearing in court.

Let's now look at the different methods:

Relative valuation

Relative valuation means that you investigate what other similar businesses sold for in the past. It is one of the simplest types of company valuation.

For example, if ten businesses have been sold recently, you can take the average or median price of these and possibly adjust with a discount or premium depending on the nature of the business.

It provides a good indication of appropriate price, especially if it is a local business. For example, a grocery store or restaurant that is comparable to the company in question.

The problem with relative valuations is that it there is rarely enough data. There may not have been enough transactions or the information may not be available.

Looking at what listed companies are valued at and applying it to unlisted companies is not recommended either, as listed shares are usually valued significantly higher.

Substance valuation

Substance valuation is a method that can almost always be applied and is relatively simple. It is based on the net value - the difference between the value of assets and liabilities in a company.

Put simply, it is equity. So to get a quick idea, you can look for this item in the balance sheet.

However, to get it right, you need to start from the net asset value. It is based on the market value, not the book value. For example, a truck may be worth zero on paper due to depreciation, but in reality it is worth several hundred thousand dollars.

Substance valuations are good when you want a fast and conservative valuation method without speculation.

The method is well suited to companies that do not make a profit or whether to make a so-called asset transfer (asset deal).

The does not take into account profits or intangible assets.

Yield valuation

Yield valuation is the most common way of valuing companies. Often a multiple on historical profit to obtain a value.

For example, you could take historical profit for the last three years and possibly weight it to give the last year more weight. Then you multiply the profit by a multiple. Hence the term multiple valuation that you sometimes hear. Often the multiple is between 3 and 5 times the profitbut it is set individually in each company.

The method is well-established and considered robust, although some speculation is required to assess an appropriate multiple. It may depend, for example, on the nature of the ownership dependency, the scalability of the business and the size of the potential.

They also talk about multiple valuation of listed companies stocks to assess how a stock is valued over time or in comparison to other stocks. This is done with so-called value multiples such as the P/E ratio, P/S ratio or P/B ratio.

Cash flow valuation

Cash flow valuation (also called DCF valuation) can be said to be a variant of income valuation. However, instead of using historical earnings as a basis, a estimated future cash flow to calculate a so-called present value. That is what the company is worth today.

The advantage of this method is that it can also be used to value companies that are not making a profit, such as a start-up.

Unfortunately, it will be almost always highly speculative. On the other hand, the cash flow for the coming years has to be assessed, which is almost impossible in all companies except possibly in very large and stable businesses.

Firstly, you need to determine a so-called discount rate at which the present value should be calculated.

The method is so uncertain that two professional valuers can come to completely different conclusions about the value of the same company.

Liquidation valuation

Finally, we have liquidation valuation. This method is used to value companies that are to be closed down. Often in the context of bankruptcy.

Put simply, it is a kind of substantive evaluation. The difference is that a big discount is used because the company has no status on the market. "Lack of marketability" as it is called.

Basically, it means selling the assets as best you can, which is often in a hurry. Then the debts are paid back and the liquidation costs are deducted.

Which valuation method should I choose?

Which way to value companies is best depends entirely on the situation - and what type of company it is. Different business valuers also have their favorite methods.

Generally speaking, a yield evaluation where a multiple is applied to historical profits gives a good indication of the value of the business. If there are significant assets in the company, such as equipment or machinery, it can be combined with a substance evaluation.

If there is no profit in the company, the valuation can be based entirely on the net asset value. The same applies if the company is to be liquidated (regardless of any profit), but at a discount.

It is also quite common for business valuers to values the cash flow with a DCF valuation. However, this method is too speculative to provide a safe result.

Nevertheless, cash flow valuation may be appropriate for some start-ups when none of the other methods are applicable, i.e. when there is neither profit nor any assets to speak of.