Popular methods and approaches used to value a business

Key takeaways

•  Business valuation is key to understand a company’s current value.

•  Business valuation results may vary according to the method that is being used. 

•  The most utilized methods are market cap, earnings multipliers, book value, liquidation value, and discounted cash flow.

Business Valuation Explained

Business valuations are estimates of a company’s worth. 

These valuations can at times be steered by the valuer, as well as by the ultimate purpose of the exercise. 

Another key factor is the difference between pricing and valuation. The profitability of a company plays a large role in its valuation. Meanwhile, external forces such as market conditions, investor activity, cultural trends and the news of the day may influence pricing.

Situations Requiring a Business Valuation

Valuations often come into play during a company’s merger or acquisition Establishing buy-ins for investors or buy-outs for shareholders can also require valuations. 

Debt financing also usually requires a prior valuation, as the lender needs to be aware of the company’s potential to repay the loan. 

The value of a business is also often required to account for succession assets, as well as for tax purposes. In these instances, the IRS has specific guidelines that must be followed. Divorce proceedings, family disputes and legal settlements can also require a valuation. A valuation can also be a useful tool for helping executives determine the business’s primary profit centers; it can help them plan campaigns and develop strategic plans.

A business valuation is key to achieving an equitable outcome in each of these instances.

Popular Valuation Methods

Market capitalization is the total number of outstanding shares of the company’s stock multiplied by their current price-per-share. 

As an example, let us say shares of ZYX Corp are trading at $35 each and there are 200,000,000 shares outstanding.  

35 x 200,000,000 = $7 billion 

Thus, the ZYX Corporation’s market cap is $7b.

Times revenue method (also referred to as multiples of revenue) applies a multiplier to a stream of a company’s revenue over a set duration of time, such as a given fiscal year. This multiplier will vary, depending upon the industry in which the company operates and the condition of the economy at the time the calculation is performed.

Earnings multiplier  value is obtained by dividing a company’s stock price by its earnings per share (EPS). This will reveal the amount of time required for the investment to recoup the share price — if earnings remain constant.

As an example, let us say those ZYX shares trading at $35 each are earning $5 per share.  Thus, $35 / $5 per year = 7 years

Therefore, it would take seven years to realize the investment amount of $35 — again, assuming the EPS remained constant.  Evaluating this figure against that of a similar company in the same industry can reveal a stock’s value (and by extension the company behind it) in relation to its earnings.

For example, if CBA Corp also has an EPS of $5 but its share price is $20, its earnings multiplier is four years. Thus ZYX stock could be seen as being more expensive because its multiplier is seven years compared to CBA’s four. 

Discounted cash flow (DCF) relies upon projections of future cash flows adjusted to determine a company’s current market value. In this way, inflation can be taken into consideration during the valuation process. 

This calculation can help investors trying to gauge a company’s potential by indicating what it can be expected to earn going forward. The weighted average cost of capital (WACC) is used as a discount rate in the calculation, as it is reflective of the rate of return shareholders expect. 

Book value is determined by subtracting the total amount of liabilities of a company from its total assets. This will return the value of the equity shareholders have in the company, as reflected on its balance sheet. 

Liquidation value is the amount of cash a company would earn after selling all of its assets, net of liabilities. 

Enterprise value considers the market cap of a company alongside its short- and long-term debt, as well as cash on its balance sheet. This is the value most often considered when a company is being taken over by another firm. 

These are but a few of many different methods employed to arrive at a business valuation. Other approaches include replacement value, breakup value and asset-based valuation.

Business Valuation as a Tool for Investors

It is important to recognize that the why, how and who of the valuation process can cause markedly different results. Thus, it is prudent to ask why a particular valuation was conducted, how it was conducted and who conducted it, to judge the suitability of the data for a specific investor’s purposes. It is also important to consider when the valuation was conducted, as some of the variables employed in the calculations are driven by market conditions at the time of the evaluation. 

Ultimately, the valuation tool an investor considers will largely depend on the type of investor conducting the research. 

The average mainstream investor can get the data they need from research reports. Value investors will analyze available data to find gaps between price and value, guided by the philosophy that the two will eventually overlap. Meanwhile, price investors focus on the demand for a particular stock and look to get ahead of any pricing trends they may observe. Meanwhile, so-called efficient market investors eschew all that in favor of more passive approaches such as investing in index funds. 

Portfolio Diversification/Alternative Assets

Regardless of the valuation technique employed, or the style of the investor, diversification should always be among the guiding factors when assembling a portfolio. In the interest of diversification, for many investors it may also be a good idea to invest in asset classes bearing more limited correlation to equity markets.

Traditional asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less correlated with public equity, and thus offer enhanced potential for diversification. This can help protect a portfolio during periods of extreme volatility.

Alternative assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million.  Yieldstreet was founded with the goal of improving access to alternative assets by making them available to a wider range of investors.

Conclusion

It is important for investors to recognize the difference between value and pricing. Valuation tends to fail to take demand into consideration, while pricing is largely dependent upon demand. While both considerations come into play when evaluating an investment, understanding the difference between them is important and both should be given equal weight. 

Regardless of the method employed, valuations are little more than estimates. It is also important for investors to consider the nature of a company’s operations, expenses, revenues, strategies and risks before deciding to invest.