Whether you want to buy another business or you’re selling yours, it’s important to know how to valuate a company. Today we are going to look at various ways in which you can do it and see which one is more useful for the situation you’re in.
How to Valuate a Company – Techniques and Methods
1. Asset Valuation
The most concrete valuation technique is the asset one. This consists of assigning a dollar value to all the assets found on a company’s balance sheet. Then, all you need to do is to add them up. Start valuating the physical assets first, such as:
- Office furniture;
- Inventory, etc.
Next, add the intellectual property:
- Incorporation papers, etc.
You may be surprised to know that a rule of thumb says that each filed patent might mean $1 million increase in valuation. Next, consider all the principals and employees. Include the value of sweat equity as well, together with the customer relationships.
2. Market Approach
Another solution for people who want to know how to valuate a company is the market approach. This consists of estimating the earning potential of the respective company by relying on the demand on the market. The first thing you need to do is to estimate the size, as well as the growth of your market. The bigger it is, the more the business is worth.
Next, you need to assess the competition as well and see what are the barriers to entry. The more competition, the lower your valuation. On the other side, there can be some things that bring an advantage to your business, such as location, prices, etc. The final step is to look at other companies that raised money. This is similar to the way in which you valuate your house by comparing it to the others in your area. You can simply search on Google or ask professional valuation consultants.
3. Income Valuation
Financial analysts use this method a lot when it comes to professional advice on how to valuate a company. It relies on projecting the future cash flows in a company and discounting them at a rate to see their value in dollars. The discount rate usually applied for startups is 30 – 60%, for example. The younger the company is, the more uncertain its future.
There is also a variation of the method above, called EBITDA, which we should also include here. Basically, you calculate the business’ earnings before interest, taxes, depreciation, and amortization, which also gives the name of this method. Then, you need to take a reasonable factor and multiply the figure you obtained earlier. It’s easy to calculate the typical EBITDA multiples for the publicly traded companies in a certain field. You just need to take the market capitalizations, which are available online and then divide them by the EBITDA.
5. Business Valuation Formula
You can also learn how to valuate a company by applying a simple formula:
(SDE * Industry Multiple) + Real estate + Accounts/receivables + cash on hand + any other assets – Business liabilities = Business’ Estimated Value
Finding Out the SDE
In this case, SDE stands for the Seller’s Discretionary Earnings. This is a number that represents the pre-tax earnings of a business before the owner’s compensation, non-cash expenses, income, interest expense or one-time expenses. This value shows you the true profit potential of the business. Basically, you need to calculate the net income of the business by adding back in the expenses found on the tax return. Include the expenses that aren’t necessary to run the business.
Here is a brief list of the things you need to add back to the net income if you want to calculate SDE:
- Owner’s perks;
- Non-cash expenses;
- Owner’s salary;
- Leisure activities;
- Charitable donations;
- Personal expenses (purchasing a personal vehicle, etc.);
- Non-essential business travel;
- One-time expenses that won’t recur after the business is sold.
Finding Out the SDE Multiplier
Generally, the businesses sell for 1 – 4 times the SDE. This value is called the SDE multiple or multiplier. However, finding out the right SDE multiple is not as easy as it may seem. It varies a lot, depending on the industry, as well as the geographic trends, company size, business’ tangible and intangible assets, etc.
Whether you are selling or buying, it’s important to negotiate with the other person how much is up for sale. If you’re selling to an investor, you need to know that they buy 100% of the company, but you will buy 20% back on the same terms. Moreover, both of you need to consider the tax implications, the cost of interest on the debt, as well as the best projections that represent the company’s prospects. This can also depend on how much a person is interested in buying, what are they most interested in, etc.
7. DCF Analysis
A DCF analysis is one of the least popular business valuation methods available. This is an approach that allows you to forecast the unlevered free cash flow into the future. Moreover, you can discount it back today. For this, you will need to build a financial model in Excel. Many people avoid it because it needs lots of details and analysis. However, it also gives you the most accurate type of valuation. With it, you can forecast value depending on various scenarios. It even allows you to perform a sensitivity analysis. If you have a larger company, the DCF method often resembles a sum-of-the-parts analysis. Here, different business units are analyzed individually and then added together.
You can learn here how to apply the DCF method to a business:
To draw a conclusion, these are 7 main ways to learn how to valuate a company. Each analyst has its own preferred method, but all of them help you assess the true value of a business. It is recommended that you try several methods and see what result you’ll get.
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