Business valuation is a practice that can be easy to understand and hard to master. Often it will also be hard to understand, however, we believe this is due to writers and scholars making the valuation concepts way too hard to read and understand, because in practice the concepts are quite simple.
In the following, we will explain the three most widely used valuation techniques. We will start by defining and explaining the three methods using a fictional pizza restaurant as an example so everyone can understand it (the easy to learn principle). Following this we will step-by-step dive deeper into the methods (hard to master principle).
There are basically three different ways of doing a valuation. These three methods are very distinct and should ideally be used in conjunction to “triangulate” the value of a business and the valuation methods could potentially yield very different estimates of a company valuation. For the different valuation methods, we will also highlight how, when and for what type of companies they should be used.
Net asset valuation (the simplest way and easy to understand):
The first method we will dive into is the asset based approach. In net asset valuation, you basically ask the question: “If I sell everything this company owns, what is the amount of money I will get in my hands?”.
The steps to perform the valuation are the following:
- Determine the value of your assets (you will then have enterprise value)
- Subtract the liabilities of the company (i.e. what you owe to debtors and other stakeholders)
- What remains as with you as the owner will receive for the business (equity value)
Simple as that! Let’s use a pizza restaurant example and perform the steps just outlined.
Example: Net asset valuation
Step 1: Determine the value of your assets
You own a pizza place. In this pizza place there are several items that you own, most notably the pizza oven and the furniture of the restaurant. To find out what these items are worth we call up the accountant and get last year’s balance sheet:
|Non-current assets (pizza oven)||10,000||Equity||10,000|
|Other non-current assets (chairs, tables)||5,000||Debt payables (bank loan)||6,000|
|Inventory (cheese, ham, dough, etc)||3,000||Trade payables (supplier of cheese, ham, etc.)||3,000|
|Total assets||20,000||Total liabilities||20,000|
The value of the pizza oven is USD 10,000, the chairs and tables are another 5,000, your inventory is worth 3,000 and you have 2,000 dollars in the cash register. Adding these numbers up we get that the value of all assets, or the enterprise value is USD 20,000.
Step 2: Subtract the liabilities of the company
Before you can get the money you have to pay your liabilities. Here you have a bank loan of 6,000, you owe 3,000 for your ham and cheese (inventory) and you owe another 1,000 to your employees. In total, there are liabilities worth $10,000.
Step 3: Remaining value = equity value
After having netted out all liabilities you are left with 10,000 in equity (enterprise value of 20,000 minus liabilities of 10,000).
When to use net asset valuation:
There are two basic types of companies, where the net asset valuation will yield a good estimate of the business value. They are companies going out of business and companies that are very asset heavy (fx. shipping companies and companies owning oil & gas).
We started by valuing the entire business (enterprise value) of $20,000. We paid off the creditors ($10,000) and were left with $10,000 for the owner (equity value).
The second valuation method is that of relative valuation. The premise is to use companies similar to yours (often this will be competitors) and use their price relative valuation to value your company. You can both use companies similar to yours that are listed, as well as companies that have been traded in private transactions. If you are a smaller company, the latter will usually be the most realistic and feasible, whereas if you are the CEO of Coca Cola, a natural listed peer would be Pepsi.
The steps to perform relative valuation are the following:
- Identify companies comparable to your own
- Obtain information about their trading prices (this can be hard in private transactions)
- Use multiples to find the value of your business
So let’s return to our pizza restaurant example.
Example: Relative valuation
Step 1: Identify comparable companies to your own
There has recently been two other pizza restaurant that were sold in your town. These will serve as pricing points for us.
Step 2: Obtain information about their trading prices
By talking to the former owners and lawyers, you figure out that the first business was sold for 5 times earnings, while the latter was sold for 6 times earnings.
Step 3: Use multiples to find the value of your business
We know what the other businesses were worth based on earnings. Before we can apply these multiples we need to look at our own income statement so we call up the accountant again. The income statement is presented below:
|Cost of goods sold||-50,000|
|Selling, general and administrative expenses||-15,000|
|Depreciation & amortization||-5,000|
|Profit for the year||20,000|
The number we are looking for is highlighted. Profit for the year (i.e. earnings) was $20,000 last year. We apply the multiple of 5 to get a value of $100,000 and with a multiple of 6, the value is $120,000. So the valuation is somewhere between $100,000-$120,000 based on relative valuation.
As this multiple is used on profit for the year this is equivalent to the equity value of the firm. This will be expanded upon on the detailed walkthrough of relative valuation.
When to use relative valuation:
I would argue that you should always use multiple valuation as it shows what other people have been willing to pay for a company like yours.
Although it can often be hard to find multiples for similar companies, it serves as a great sanity check and even when there are no comparable companies it could still be used.
Another way to use multiple valuation is to turn the question around and ask: “Do I think someone will pay me 5-6 times the earnings for my business?”.
We started by identifying two similar companies that were traded at 5 and 6 times earnings respectively. Using these multiples on our own company yielded a valuation range of $100,000-$120,000. This is significantly higher than the net asset valuation which gave a value of $10,000.
The third and final valuation method we will explore is the cash flow based approach (often, also called the income based approach). There are several methods using the cash flow based approach, such as dividend discounted model (“DDM”, adjusted present value (“APV”) and discounted cash flow (“DCF”). DCF is the method most widely used and the one we will explore further.
The premise of DCF is that “the value of the company is derived from the present value of the estimated free cash flows”. This is a sentence packed with information, but there is really only one thing we need: To estimate our free cash flows. So let’s revisit our restaurant example.
Step 1: Estimate free cash flow
You have owned the pizza restaurant for 10 years, and all these years the income statement has been the same as the one we looked at when doing relative valuation. You have revenue of approximately $100,000 and profit for the year of $20,000. It is a stable business and that’s the way it is. Since the business is very stable, we estimate the free cash flow for the next five years.
|Item||Year 1||Year 2||Year 3||Year 4||Year 5|
|Cost of goods sold||50,000||50,000||50,000||50,000||50,000|
|Selling, general and administrative expenses||15,000||15,000||15,000||15,000||15,000|
|Depreciation & amortization||5,000||5,000||5,000||5,000||5,000|
|Profit for the year||20,000||20,000||20,000||20,000||20,000|
Simple as that! Same estimated profit every year and in this example we will assume profit for the year is equal to free cash flow. Also, for this example let us assume you sell the business after five years at a multiple of 5 times earnings, so there will be a cash flow of $20,000*5 = $100,000 in five years. Our projected cash flows are thus:
|Item||Year 1||Year 2||Year 3||Year 4||Year 5||Year 5 sale||Total|
|Free cash flow||20,000||20,000||20,000||20,000||20,000||100,000||200,000|
So the total cash flow is $200,000. However, remember I said we only needed to estimate our free cash flows? Well that wasn’t entirely true. We only have the latter part of the sentence “the value of the company is derived from the present value of the estimated free cash flows”. We will thus need to figure out how we derive the present value of these cash flows.
Step 2: Estimate the discount rate for calculating present value
To get the present value of our cash flows we will need to discount the cash flows for each year. For this we will need the discount rate.
Now, the discount rate is a topic of great discussion and there are many views regarding it. In this example we will use a discount rate of 15%, which we will not dive deeper into for now.
So how do I apply these 15%? Again, we will not go to deeply into it, but the formula is: Discount rate for a given year is 1/(1 + discount rate)^n, where n is year number. So for year 1 our discount rate is 1/(1+0.15)^1 = 0.87 and for year two it is 1/(1+0.15)^2 = 0.76 and so forth. We will apply this to out free cash flow which we derived in year two.
Step 3: Calculate present value
Below is the value of our pizza restaurant using the discounted cash flow model.
|Item||Year 1||Year 2||Year 3||Year 4||Year 5||Value of business year 5
|Profit for the year||20,000||20,000||20,000||20,000||20,000||100,000|
|Value per year||17,391||15,123||13,150||11,435||9,944||49,718|
So the value of our business is $116.761 and is within the range we obtained using relative valuation. There are a few things to note here:
- Our discount rate gets smaller for every year. This is to be expected as cash flows further out in the future has less value than a cash flow tomorrow
- DCF gives us the enterprise value. So we have to deduct liabilities to get enterprise value. As you might remember from our net asset value example, there are liabilities of $10,000, so the equity value using DCF is $106,761
When to use discounted cash flow valuation:
As with multiple valuation, I would argue that you should always use discounted cash flow. However, it is relatively harder to use and it can often become a “garbage-in, garbage-out” model.
Since cash flow based valuation is “stand-alone” and only focuses uses information about the company being valued, it becomes especially strong, when there are no comparable multiples to use.
We estimated all future cash flows of the company and used our relative valuation multiples as the basis of the value of the company in year 5. Discounting the cash flows to get a present value of approx. $115,000. This is within the range from our relative valuation ($100-$120,000) and far higher than the net asset valuation which gave a value of $10,000.
I hope this has given a solid introduction to the valuation concepts most widely used to value a company. In the basic section above, we have taken many shortcuts, however, I believe this is important when trying to understand how the valuation techniques work. In the advanced section below, we will expand greatly on the concepts discussed, however, it should not alter the basic understanding of the models.
In our example we implicitly assumed that the book value of our assets were equal to the resale value of the items. But what if we have to sell the items within a week?
When looking at the balance sheet from previously we see, that some items may be easier to get full value for then others. As an example, we would assume we could get 1:1 value for cash. Further, our pizza oven is also an asset that is reasonably easy to sell, whereas our inventory (cheese, ham, dough, etc.) is probably impossible to sell due to it rotting.
Below, the revised balance sheet with resale value is stated, as well as the discount to these items.
|Assets||Book value||Auction value||Discount|
|Non-current assets (pizza oven)||10,000||6,000||40%|
|Other non-current assets (chairs, tables)||5,000||2,000||60%|
|Inventory (cheese, ham, dough, etc)||4,000||0||100%|
Now we have an auction enterprise value of $10,000. As we also have $10,000 in liabilities the equity value is now zero. This is often called the distressed net asset value as we couldn’t sell the assets in an orderly fashion on our own terms. Similarly, the method we used in our previous pizza restaurant example is called orderly net asset value.
Even in orderly net asset valuation, it is often hard to get full value for intangible assets. Below, we will also list other items, that are hard to get value from when doing net asset valuation.
Goodwill: Will often be impossible to get value for, as goodwill will normally only have value to the company being considered.
Patents: Very hard to value. Value might be significantly higher than book value but will in most cases have very little value.
Trademarks: Again, the value can vary a lot. If Nike were to liquidate the company, the brand value of Nike would be very high. If it is a company going out of business the brand value will be lower (for example Enron and Lehman Brothers).
Copyright: This will normally yield a value closer to the value to the company. As an example, say you have a copyright on all Beatles songs. It is relatively easy for outsiders to value these so it will normally yield a relatively good value without significant discount.
Licenses: Say you have a license to sell Nike products in the US. This will be easy to sell and will likely be close to book value. Other licenses (for example a right to drill oil on Greenland) may be worthless given the current low oil price.
Net asset valuation, conclusion:
All in all, while net asset valuation is simple and intuitive to understand, there can be a range of items that are hard to value. The method is best used for companies going out of business or alternatively, to see if the assets of the company can be better used somewhere else.
The net asset value should thus serve as the minimum value of the business.
In our example, we assumed that earnings was equal to profit for the year. However, while it might be correct, we have no way of knowing that. Earnings could also mean EBIT, EBITDA or another earnings related measure on the income statement.
Let’s for a second assume that earnings was not profit for the year, but instead EBIT. Remember EBIT was $30,000 and using the earnings multiples of 5 and 6 from before would now yield an Enterprise Value of $150,000-180,000 (and an equity value of $140,000-170,000). This is quite a large difference in valuation, which takes us to the first thing to remember:
1# Understand exactly what multiple is used
As shown above, using a multiple on a faulty income statement item will lead to large variations in valuation. The most common multiples used are:
- Price/earnings multiple (P/E multiple)
- Enterprise Value / EBITDA (EV/EBITDA)
- Enterprise Value / EBIT (EV/EBIT)
2# Ensure the comparable multiples are really comparable. If not, make sure to account for this
Let us revisit our relative valuation. Now we learn that another pizzeria was sold for 10 times profit for the year. To understand why it was sold for a much higher price we analyse this pizzeria. We learn, that it had been growing rapidly and is becoming very popular and so forth. In other words, while the business is basically the same (same industry), it’s business characteristics are very different form your pizzeria which is a stable business without much growth in it. Thus, if we were to use this multiple it would yield an erroneous valuation as the two companies doesn’t have the same characteristics.
Some of the most important business characteristics are:
- Being in the same industry
- Similar expected growth rate (higher growth, higher value)
- Similar brand value (higher brand value, higher value)
- Similar profitability (relative, not absolute – higher profitability, higher value due to higher profitability from scaling/growing the business)
- Similar size (larger companies, higher relative valuation)
3# Normalization of earnings
In our pizza restaurant example, let’s assume that salary is paid to both husband and wife. Each receives $20,000, but the it is the wife that runs everything and the money for the husband is basically pocket money – he doesn’t have any function.
Thus, when valuing the business his salary of $20,000 should not be included as the next owner would not pay this, i.e. you “normalize” earnings. Not accounting for tax effect, profit for the year would double and rise to $40,000. Thus, using a multiple of 5-6x, the company would now be worth $200,000-$240,000.
Common normalization effects to consider:
- Salary to a person, who has a legacy in the business but no real function
- One-off items. As an example, if our pizza restaurant was closed for two months due to thunderstorm damages, earnings should be normalized as if it had been opened during these two months
- Other one-off items would be firing a CEO and paying a parachute payment to him/her
4# Use current or expected earnings?
In our example, the business was expected to have the same profitability in the years to come. But if, profits were expected to double in the next year, the business value would be grossly underestimated due to historical profits being significantly lower than expected earnings. In such a case, it would be prudent to use forward-looking estimates instead of backward-looking figures.
Relative valuation, conclusion:
There are a host of variables to consider when using relative valuation, but the most important rule to remember is: “The more our business share with the business whose multiple we use, the more precise a multiple valuation will be”.
#1 Use free cash flow, not profit for the year
In our example, we assumed profit for the year is equal to the free cash flow. Although this can be a good approximation it is also a very liberal assumption to make, and the first part of this section will focus on how to get free cash flow. The method is:
+ Depreciation & amortization
– Capital expenditures
+/- Changes in net working capital
= Free cash flow (pre-tax)
– Tax on EBIT
= Free cash flow (post-tax)
The intuition is, that we value cash flow, not profits. Depreciation & amortization has no cash effect so these should be added to our EBIT. Further, capital expenditures have no direct income statements effect, but has a very real effect on our cash flow. Finally, if more (or less) money has been tied up in net working capital (i.e. trade receivables, inventory), this will also lessen the cash flow to the owners.
#2 How to estimate the discount rate (WACC)
This is one of the large areas of literature in the academic world, and it can be extremely technical. The main rule to remember is, that the higher the risk, the higher the discount rate should be.
So, actually, I am not going to go further into the issue here. Instead, if you are looking for cost of equity, cost of debt and the two blended together for the industry you are in, please visit Aswath Damodoran’s “Cost of Capital by Sector”.
The cost of capital on the site, does not take into account that smaller companies command a size premium to their discount rate, i.e. the discount rate is generally higher for smaller companies compared to larger companies, so please take this into account as well.
3# Estimating terminal value (value in year 5 in our example)
There are two widely used ways to estimate the terminal value. In our example, we used a multiple to value our firm in year 5.
The other often used (and more academic) way, as to use [Gordon’s growth model]. The formula is:
Terminal value = Final cash flow * (1 + long-term growth rate) / (discount rate – long-term growth rate).
Long-term growth rate will often be set at the rate of inflation which is 2%. The other values in our example were $20,000 for final cash flow and a 15% discount rate.
Our terminal value is thus:
$20,000 * (1 + 0.02) / (0.15 – 0.02) = $156,923
This is significantly higher than the value of $100,000 we got using relative valuation.
It should be remembered, that this is a year 5 cash flow and should be discounted with the appropriate rate to get the present value.
A final note regarding terminal value: Terminal value will often be a high proportion of the enterprise value you will get. As it is very sensitive to small changes in assumptions, it can be recommended to prolong the estimation period to for example 10 or 20 years, to get more nuance into the model.
Discounted cash flow, conclusion:
With all this being said, discounted cash flow models are often seen as “garbage in, garbage out” models. This is often due to optimistic business plans that when applied to a DCF model, yields valuation that give a value of more than 20x earnings.
However, if a sound and thorough business plan is applied to the model, the model is very strong and should be the cornerstone to guide any valuation.
Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions by Jushua Rosenbaum & Joshua Pearl
Valuation: Measuring and Managing the Value of Companies by Tom Koller