Company Valuation:- Like any product we sell on the market, companies have value. Is the value of a company the same as the sum of the value of its assets? Moreover, Is there any objective method that will help us in the task of determining the value of the company?
Why Company Valuation is Important
Companies value their company to know what resources they have available to generate future income. These resources are represented by the assets of our balance sheet. Therefore we do not value only when buying or selling the business, but every time we do the accounting monthly, we are calculating a total value for the accumulated equity.
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This is one of the purposes of accounting: determine the cumulative value of all our business actions. The net worth of the company represents the value corresponding to the shareholders.
However, it is clear that accounting can not capture the full value of our assets. For example, having a talented and motivated employee is not something that can be reflected in our accounting.
Hence, valuation methods are necessary to help us determine a more objective value.
Methods – Company Valuation
There are many methods of valuation. Here we will summarize three of the most used.
The balance sheet method consists in taking the balances recorded in the balance sheet and revalue them according to some specific criteria. Let’s see an example.
Every company has the following balance:
- Fixed assets 1000
- Stocks 50
- Banks 50
- Net worth 200
- Debt 900
The company proceed to reevaluate heading to heading the balance sheet. Fixed assets have a market value of 1,500 currency units, while stocks have a market value of 100 units.
Therefore the value of the company following the balance sheet method would be as follows:
- Fixed assets 1,500
- Stocks 100
- Banks 50
- Net worth 750
- Debt 900
The advantage of this method is that its starting point is the accounting quantities that are already specified in the balance sheet. Though, the main drawback is that it is easy to determine the settlement value of a specific motive, it is much more difficult to know how much that asset is worth in combination with the other resources of the company. Also that integrated value is precisely what motivates the buyer of the business.
The multi-valuation method consists in using certain accounting aggregates and comparing them with the average of the companies of the same sector or with the multiples of any company that has been acquired previously.
Here are the most common multiples mentioned below:
For example, based on previous transactions we can determine that the value paid by food companies in recent years is 5 times EBITDA. If our company has an EBITDA of 1000 um, the calculated value will be 5000 monetary units.
Furthermore, the main advantage of this method is the simplicity of calculation. The main drawback is the lack of an objective criterion to help us understand why the multiples of a sector have a certain value.
Cash Flow Discount
The cash flow discount method is based on the principle that every asset must be valued based on the future income it may generate. Therefore the value of the company will be equal to the value leave updated cash flows at a discount rate.
For example, suppose that the company plans to generate cash flows of 1000 a year over the next 10 years. The discount flows at a rate of 5%.
- Company value = 1000 / 1.05 + 1000 / 1.052 + 1000 / 1.053 + .. + 1000 / 1.0510 = 7722 one
- The discount rate represents the risk. At more risk, the rate is higher.
So, the advantage of this system is that it allows linking the valuation with the business plan of the company. The main drawback is that the discount rate is not always easy to determine.
What is the best method of Company Valuation
Among the methods discussed, the method of discounted cash flow is the most complete, allowing delving into the business plan used to calculate flows.
Multiples and balance methods can be used as a complement to ensure that the valuation is in line with other transactions and is also consistent with accounting information.
Hello everyone! This is Richard Daniels, a full-time passionate researcher & blogger. He holds a Ph.D. degree in Economics. He loves to write about economics, e-commerce, and business-related topics for students to assist them in their studies. That's the sole purpose of Business Study Notes.
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