Book value and 6 more business valuation methods

Business valuation is a way of determining a company’s fair market value. Analysts examine a series of factors in their business valuation, such as the market value, past and projected cash flows, or the total asset value.

Key takeaways

• One should always combine different valuation methods to obtain the most accurate picture.
• Business maturity, economic climate, and asset tangibility should be considered for business valuation.
• The more calculations a method involves, the more accurate the results can be.

Why would you need a business valuation?

Business valuation is required in several situations:

• Selling a company.
  A seller needs to establish a competitive target price for a company and develop a beneficial sell agreement.
• Mergers and acquisitions.
  The business valuation is crucial for productive negotiations and due diligence during a merger or acquisition to determine the business’s worth. 
• Capital raising.
  Companies and individual investors assess business value to ensure it corresponds with the market, determine its potential, and calculate ROI.
• Public offering.
  Private companies determine the business value to set an initial share price for the public offering.
• Tax reporting.
  The Internal Revenue Service (IRS) and other tax authorities require a business valuation to collect taxes.
• Divorce proceedings.
  Many business owners require financial valuations to determine asset ownership for fair divorce.
• Miscellaneous.
  Business valuation is conducted for insurance, restructuring, strategic planning, and many other purposes.

Business valuation criteria

There are several criteria an analyst should consider before starting a business’s valuation:

• Business maturity.
  Startups are highly volatile and may incur losses or earn explosive profits due to skyrocketing sales numbers. In contrast, businesses with time-proven history are more predictable.
• Economic climate.
  Several circumstances, such as economic development, location, and emergencies, can disrupt initial market value assessments.
• Asset tangibility.
  Tangible assets do not always result in higher value estimations. Intangible assets, such as computer software, may be attractive long-term investments.

Top 7 common business valuation methods

Company valuation is a complex procedure that involves several approaches applied to different areas of a business:

1. The book value valuation method
2. The market capitalization of earnings method
3. The earnings valuation method
4. The discounted cash flow (DCF) valuation method
5. The times-revenue method
6. The historical earnings method
7. Guideline transaction method

1. The book value valuation method

The book value or asset-based valuation method determines the net asset value (NAV) of a business by analyzing the company’s balance sheet. 

The balance sheet includes the business’s assets, such as real estate, stocks, cash, equipment, and intellectual property (trademarks, copyrights, patents, etc.), and liabilities.  The asset-based valuation method calculates the liquidation value of a company accurately as well.

NAV = Total Assets – Total Liabilities

For instance, Facebook (META) had $178.89B in assets and $22.69B in liabilities for its third fiscal year. 

• $178.89B – $22.69B = $156.2B NAV

Pros:

• Easy formula.
• Useful for asset-intensive businesses or financially-distressed companies where bankruptcy is followed by an auction of their assets.

Cons:

• Company earnings are not considered under the asset-based valuation.
• Intangible asset evaluation is complicated.
• Adjusted net asset method is required to get the fair market value of a business.

2. The market capitalization of earnings method

The market approach estimates the economic value of a company by calculating its capitalization of earnings. 

Market Value = Total Shares × Price per Share

The Alphabet (Google) company owns ~12.94B shares at $99.16 per share as of 27.01.2023. 

• Market cap = 12.94B × $99.16 = $1.27T, which aligns with its actual capitalization of earnings.

Pros:

• Simple calculations.
• Useful for companies seeking investors and vice versa.
• Useful for comparative market analysis as it tells about the company’s size and estimated present value.

Cons:

• Share numbers and prices fluctuate, representing a snapshot of a company’s value at a specific time.
• Company’s balance sheet, including debts, liquidation value, net cash, and other aspects are not considered.

3. The earnings valuation method

The profit-to-earnings valuation method (a.k.a. P/E ratio) evaluates the price of a company’s shares relative to its earnings per share (EPS). A ratio below 20 is considered to be a stable investment.

P/E Ratio = Market Value per Share ÷ EPS

EPS = (Net Income – Preferred Dividends) ÷ Average Outstanding Shares

Pfizer reported $29.77B income and 5.718B shares at $44.50 per share and $6.73B in preferred dividends

• EPS = ($29.77B – $6.73B) ÷ 5.71B = $4.02
• P/E Ratio = $44.5 ÷ $4.02 = 11.06

Although the P/E ratio doesn’t tell us much about the present value of a business, one can use it to evaluate other comparable companies in the same industry.

Pros:

• It helps investors choose growth (high P/E) and value stocks (low P/E).
• It is easy to get an earnings-based value of a business.

Cons:

• The liquidation value and future profitability are not considered.
• Volatile stock prices can render P/E calculations useless in the short term.
• It is difficult to evaluate the company’s worth, as previous earnings may not represent its current situation.

4. The discounted cash flow (DCF) valuation method

The income approach or discounted cash flow analysis (DCF) calculates the expected future cash flows of a business in a given time frame. Discounted cash flow determines the current market value of an investment by projecting the company’s expected value.

Let’s say Tesla increases stable cash flows steadily at a 9% rate, from $11.44B in 2022 to $12.46B, $13.59B, and $14.81 in 2023,  2024, and 2025, respectively. The discount rate is 12%.

• DCF = ($12.46B ÷ (1 + 0.12)^1) + ($13.59B ÷ (1 + 0.12)^2) + ($14.81B ÷ (1 + 0.12)^3) = $32.56B

Pros:

• Provides accurate valuation of the expected net income.
• Considers business growth expectations.
• Helps investors calculate the ROI.

Cons:

• Complicated and sensitive to error.
• Unlike the asset-based valuation, it heavily depends on assumptions as its extended version calculates a highly approximate terminal value.

5. The times-revenue method

The times-revenue (TR) method determines how many times the annual income a buyer would be willing to pay for the company. 

TR Formula = Selling Selling Value ÷ Previous Fiscal Year Revenue

The times-revenue valuation method determines how many years of earnings will be necessary to recoup the purchase price of a business, which can be useful when comparing it to similar businesses.

Google acquired DoubleClick for $3.1 billion in 2008, while DoubleClick generated $300 million the previous year. 

• TR = $3.1B ÷ $300M = 10.3, meaning it would take Google 10.3 years to recoup their investment. 

However, Google’s ROI of this acquisition was $123.3 billion in 2019-2020, 410 times higher. 

Pros:

• One of the easiest methods of valuation.
• Helps to establish the highest selling price quickly.

Cons:

• Provides an estimated value only and can be inaccurate based on the DoubleClick case.
• All the assets, liabilities, and growth forecasts are excluded.

6. The historical earnings method

The historical earnings (HE) business valuation method calculates a company’s past performance to estimate the amount of goodwill the market has toward it. It usually involves the highest earnings before interest and taxes (EBIT) and the minimum required rate of return (RRR) accepted by investors.

Historical Earnings Formula = EBIT ÷ RRR

Let’s say Company B has a 5% required rate of return and the highest EBIT of $2B.

• Historical Earnings = $2B  ÷ 5% = $40B

Pros:

• Gives an understanding beyond the company’s intrinsic value.
• Often more connected to real-world future profits.

Cons:

• Disregards other business metrics.
• Sensitive to error due to complex RRR calculations.

7. Guideline transaction method

The guideline transaction business valuation method (GTM) calculates a company’s current value by estimating comparable companies during the transaction. This method reviews the business based on the price-to-sales ratio (P/S) of similar companies before acquisition.

GTM = Subject Business Annual Revenue × Median P/S ratio of Similar Businesses

P/S Ratio = Market Value per Share (MVS) ÷ Sales per Share (SPS)

SPS = Annual Sales ÷ Average Outstanding Shares

Company S has $490 million in annual gross revenues. One has data on five similar companies with P/S ratios calculated.

• Median P/S ratio = (3 + 4.6 + 2.06 + 2.19 + 2.08) ÷ 5 = 2.78

Once you have median P/S ratios, you can calculate the subject company’s sale value under the GTM method:

• Final value = $490M × 2.78 = $1.36B

This example intends to show the GTM evaluation process and does not represent the complete review as many more companies need to be analyzed. Generally, appraisers review thousands of historical transactions and leave 100-200 of the most relevant ones for analysis.

Pros:

• Gives an accurate value if there is sufficient data.
• Does not use predictions and calculates actual money.
• Is easy to understand and calculate.

Cons:

• Assessing historical transactions is challenging as many crucial indicators are missing.
• Must be combined with other methods of valuation calculating net cash flows, liquid assets, and other metrics.

Conclusion

The true valuation of a company is often outside the realm of precise calculation, as there is no ideal valuation approach. However, one can get a close-enough appraisal from which to make their decisions by combining several or all the business valuation methods.

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