Company valuation methods

company valuation methods

company valuation methods

Issue of company valuating is not something new, especially for countries with developed economy. There is a great part of evaluating that depends on subjective perspective of evaluator, for example because of the important factors of evaluating – time factor and the risk – the core items affecting the results. That means that every evaluator determines the result value of the company or part thereof in a different way and evaluating itself is always demanding. The company creates the value only if it has a competitive strength and it dispose with some significant competitive advantage. Evaluating of a company is a tricky thing to do and the accounting standards are not exact enough for the company valuation, because it abstracts from much influencing information. The starting point of financial management and all the related indicators lies in the statements of financial accounting in the form of balance sheet and income statement.

A long time ago many managers had realized that monitoring and evaluating the company’s performances and the company itself based on the variables like profit or revenues is insufficient. The main problem is that these variables are solely connected to the past while the value of the company has to contain also its future potential. It means that the traditional attitude has to be changed to the modern one with the new indicators and methods. Value is not only related to the numbers and money in the accounting, it should be considered in connection with the company’s objectives, plans, strategy and the market.

Literature recommends use the following steps by the valuating process:

  • Input data collection,
  • Data analysis
  • Financial plan

Input data collection – This is the first step where the evaluator can hit a snag. Character of the data is conditioned to answer two questions: What’s the purpose of evaluating? What kind of value should be determined?

In general, evaluators have to have all the information about the company itself, accounting statements and relevant market. They also need to know the competitive structure, competitive advantages, marketing activities and they have to consider all the stakeholders and relations among them.

Data analysis – consist of 5 parts:

  • a) Strategic analysis – according to experts this phase might be the key to the right valuation. This part will determine the return potential of the company that can be expected in the future, considering the risks and the probabilities. The calculation begins with the information about revenues and that follows the time series analysis and the subsequent extrapolation, regression analysis and the estimates of future sales trends and market situation.
  • b) Financial analysis – financial health detection in the company consist of capital and assets structure examination, financial statements analysis, financial ratio analysis and also the synthesis of the partial results. Traditional ratio analysis uses the indicators of liquidity, profitability, activity and solvency. Part of the solution and calculation is also their pyramidal decomposition for better understanding of their mutual connections.
  • c) Distribution of assets on operationally necessary and unnecessary – every company has the main focus of the activity, the purpose of its existence, which has to be separated from the other – lateral – activities. Operationally necessary assets are usually evaluated using different methods than the unnecessary ones, because these are considered to be part of the company’s value.
  • d) Analysis and forecast of value generators – under the value generators can be understood as the set of a few basic parameters, which, in general, can influence and help to determine the value of the company. Generators can be expressed by financial indicators. Among the different sub-indicators and the top indicator are the connections that have to identify with utilizing pyramidal decomposition.
  • e) Approximate valuation based on value generators – the first estimation of company’s value comes in this step, based on the Free Cash Flows.

Financial Plan – Especially for the income methods there has to be created complete financial plan to the future. It involves the pro-form of three accounting statements: income statement, balance sheet and cash flow statement. Financial plan is derived from the long-term concept of the company (the vision and its strategy) while including all the other plans transformed to numbers.

Evaluation – this part consists of another 3 significant steps:

  1. a) Choice of method – We also know many methods from the corporate finance theory and the most common in practice are those ones based on the assessment of income. Choice of method is an important step but all these methods are usually used in the combination which leads to the compliance of the company’s value. There are lots of different methods in this field, but they can be classified in groups of approaches as follows:
  • Economic Valuation Approach
  • Market Value Approach
  • Asset Value Approach.

Economic Valuation Approach

Economic Valuation Approach involves the so-called Income-based business valuation methods. This group of methods is based on the consistent use of the knowledge that the value of a company is determined by the expected benefits for the owner – in the form of incomes. They work with the incomes using techniques of discounting and capitalization. To this group of methods belong for example:

Capitalization of earnings

Multiple of discretionary earnings

Discounted cash flow – it is possible to calculate with FCFF (free cash flow to 
the firm), FCFE (free cash flow to the equity) or DDM (dividend discounted 
model). Market Value Approach is based on the comparison to another companies evaluated in the 
past while considering similar businesses. This approach consists of methods like:

Guideline publicly traded company method

Comparative transaction method.
Asset Value Approach methods let you determine the company’s worth based on the values 
of its assets and liabilities. The main asset valuation methods are:

  • Excess Earnings Method
  • Asset Accumulation Method

Legislation provides just certain limited methods of valuating 
that are basically used by expert witnesses who are governed by the related law and decree (Equity methods, Business methods, Combined methods, Liquidation methods and Comparative methods). For example, combined methods are worth mentioning, because they seek a compromise between the capital appreciation (assets approach) and the income approach. These methods are often considered as corrected income methods and they are generally used to synthesize the results of the valuation methods based on income and property (assets). They combine income and equity method, which means that according to them the company’s value is created by performances of the company, as well as the future income. The advantage of this method is averaging income and substance’s value, which can eliminate inaccuracies and uncertainties associated with each of these methods. The possibilities of using this method are limited, because you can calculate it only if the particular results gained from income and asset methods are at the similar lever – they are comparable, which is a disadvantage of combined method.

  1. b) Evaluation of a company based on selected methods – The thing is that for everyone has the object of valuation a different value, which means that it is very unlikely, that two experts would determine the same numbers as a result. Especially in this case whole company should be evaluated. Uncertainty of the results depends not only on the subjectivity of the appraiser, but also on the choice of a method he uses. We know three basic kinds of methods, as mentioned above: income, assets and market methods. Each of these is recommended to be used for a company in a certain situation. We can take an example: When is the company heading to liquidation, the estimator wants to find out the liquidation value by liquidation method. This kind of value might be also used in another companies as well, for example it can delimit the lowest level of the value for prospering and perspective companies.

All the numbers from calculations using appropriate methods should be consider being only the partial results that became an input data for the synthesis. Valuators have to take into account all the influencing factors, so that they would specify the company’s value as exactly as they can.

  1. c) Summary of evaluation – Evaluation by synergy of used methods is the most difficult part of valuating process. It actually means that there are more evaluating methods used at the time, so that the explanatory power of the results is improved. Each method must be assigned with a function and weight, leading to a single final value. Experience has also proven that an incorrect assessment can be for example one of main reasons of an acquisition projects failure.

Business owners and managers must have some vision of the company in the future and the basic assumption for it is to find out how good runs the company now and what is its actual value. After achieving specific results comes next important part of management – management of an enterprise value – and if it will be done the right way it would lead to substantial improvements in their performance. For intuitive valuations and subjective judgments of experts shall stand amount of information and knowledge on the issue. Each expert should always accurately describe (in the review he writes) all the data he relied on and all the facts, that have had an impact on the resulting value. That is the way of making the entire process transparent and auditable.