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Three common methods of valuating a business
There are three common methods of valuating a business:
- discounted cash flow (DCF)
- asset-based valuation
- valuation multiples.
Determining the value of a business
There are three common methods of valuating a business: discounted cash flow, valuation multiples and an asset-based valuation. Read our tips for a successful valuation of a business.
Discounted cash flow
Discounted cash flow (DCF)
In theory, determining the value of a company is simple: the real value of any company is the present value of its total future cash flows. If a business is expected to generate a steady future cash flow, it’s easy to determine the value of the company. DCF refers to a valuation method that estimates the value of a business using its expected future cash flows. A discount rate reflecting company’s cost of capital is used to discount all future cash flows to calculate the net present value. In practice, however, forecasting future cash flows is relatively difficult, which is why other valuation methods are often more popular.
Asset-based valuation
Valuation multiples
Actual transaction price is a result of the negotiations
The various valuation models are theoretical, as they are based on financial statements data. The real value and the potential transaction price of a company are also impacted by many other factors. SMEs don’t have a liquid market, which is why their transaction price in a business acquisition is influenced by a combination of factors. The final price is agreed on during the negotiations and depends on the circumstances and motivations of both the buyer and the seller at the time. Factors that bring the price down are often related to the seller’s circumstances and poor profit trends, which increase the buyer’s bargaining power, or the fact that the seller is ill-prepared for the acquisition process. Conversely, factors that raise the price include the target company’s attractive strategic position and strong foothold in its market, a large number of prospective buyers and a well-prepared acquisition process.
Business valuation as a tool in value creation
Valuation methods provide a solid framework for business development even if you’re not planning to sell your business. They may help you prioritise certain actions and think about goals that might be less obvious than enabling growth and cutting costs, for example.
The means for growing your company’s value are, however, not dependent on its current valuation and actual value. Growing net sales and accelerating this growth will naturally increase your company’s value as long as the growth is profitable. Profitability is widely measured by the EBITDA percentage and the return on equity. Increasing profitability increases value, as does risk management. Investments tie up more capital. Your company’s value is measured by the return on capital, which means that tied up additional capital decreases its value. Capital tied up in working capital is just as significant as capital used for investments. Value decreases when working capital increases. Your company’s value is measured by the return on capital, which means an increase in the return requirement and cost of capital decreases the company’s value. The most obvious way to increase your company’s value is profitable growth.
