Use A Technique Appropriate to Your Objective
You know that you should obtain a valuation of your company when you decide to sell your business. However, proper financial management dictates that you obtain a valuation of your company at other times as well. For example, you want to get a value when you set up an equity sharing plan, transfer stock, execute a buy-sell agreement, and meet with investors to raise capital.
There are several methods for valuing a company. The purpose of the valuation often dictates the method used. For example, you may want a different value for tax purposes than you will if you are selling the company. Here are the various methods commonly used:
- Book Value — This is a relatively simple process, where you take the sum of all assets and subtract the value of all liabilities. The result is the book value. The drawback to using this method is that assets will typically be undervalued because accounting rules require that values be recorded at historical cost.
- Replacement Value — A variation on the book value method, this formula uses replacement value instead of book value for each asset. The result is a typically a higher valuation than would be obtained from the book value approach.
- Negotiated Price — Commonly used when stockholders are executing a buy-sell agreement, in this method the parties involved simply agree on a value, such as a multiple of earnings or the net book value.
- Return on Investment — In its simplest form, the return is calculated by dividing the net profit by investment costs. This method recognizes that earnings are an important element of a company’s value. The drawback is that it also requires a projection of future earnings, which means the calculated value is based more on educated guesses than actual, verifiable data.
- Market Value — To obtain a valuation using the market value approach, the appraiser looks at similar companies that have sold recently, and uses their sales price to determine a price for your company. While this may provide a more accurate assessment of value, in practice this method can be difficult to apply because it may be difficult to find a similar company, or to find one that has recently been sold.
- Cash Flow — There are two variations on this approach. The free cash flow method bases a company’s value on the future projected amount of available cash, net of noncash items and capital expenditures. A discounted cash flow approach takes applies a discount rate to future net cash flows to calculate a present value of the company.
- Multiple of Earnings — This method applies a multiple to the earnings before interest, taxes, depreciation and amortization. The appropriate multiple to apply is usually based on a standard multiple for the industry, adjusted for factors that add to or detract from the value of the company.
Remember that each method will yield a different result, so the best approach is to pick more than one method, then compare results or apply a weighted average to determine the most likely current value for your company.
Originally published in Kaufmann’s Capital Comments.
Practical Information. Process Improvement. Profit Enhancement.
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