Three Basic Methods of Business Valuation

If you’re considering selling your company, it helps to understand methods of calculating value to ensure you get the best price. Some of the simpler methods discussed here involve considering the company’s market capitalization (based on issued shares and share value), analysing historical sales of comparable companies, or using industry-wide multipliers to determine market value.

METHOD 1 – Calculating Market Value Using Market Capitalization

The simplest and most reliable method to determine a company’s market value is to calculate its market capitalization. The market capitalization is defined as a company’s share value multiplied by the total number of shares issued. This method is used as a measure of a company’s overall size.

• Note that this method only works for publicly traded companies, where share values can be easily determined.
• A disadvantage of this method is that company  valuation is subject to  market  fluctuations. If the share market declines due to external factors, the company’s market capitalization will decline despite its financial health.
• Market capitalization relies on investor confidence, and is therefore volatile and an unreliable measure of a company’s true value.

APPLICATION

1. Determine the company’s current share price.

This can be determined by checking the share price information made publicly available by the stock exchange.

2. Find the number of shares issued.

This information can also be found through the stock exchange or through an online search of the company. Information on the number of shares issued is publicly available.

3. Multiply the number of shares issued by the current share price.

This figure represents the total investor value in the company, giving a fairly accurate picture of the company’s overall capital value.

Example
Xero’s share price at the time of writing (11 July 2017) was $25.75. The number of issued shares was 137,826,238.

$25.75 x 137,826,238 = $3,549,025,628 (market capitalisation)

METHOD 2 – Finding Market Value Using Comparable Companies

This valuation method works well if a company is privately held. To estimate a company’s value, look at the historical sale prices for comparable businesses.

• Market capitalization may be deemed unrealistic if a company’s value is mostly held in intangible assets and investor speculation drives the price up way beyond reasonable limits.
• This method has several shortcomings. First, it may be difficult to find enough data, as sales of comparable businesses may be infrequent. Also, this valuation method does not account for significant differences in business sales conditions, such as whether the company was sold under duress.

APPLICATION

1. Find comparable companies.

There is some discretion involved in choosing which businesses are comparable. Companies considered should be in the same industry, be roughly the same size, and have similar sales and profits to the company you want to value. In addition, the business sales should be recent so they reflect more or less up-to-date market conditions.

• If you are determining the market value of a private company, you can use publicly-traded companies of the same industry and size for comparison  by using the market capitalization method and searching online.

2. Create an average sale price.

After identifying recent sales of comparable businesses or valuations of similar, publicly-traded companies (usually 3 as a minimum), establish an average sale price. This average value can be used as a bench mark for the market value of the company in question.

• You may wish to weigh the different values based on their closeness to the target company. For example, if one is of very similar size and structure to the company being estimated, you may choose to assign a higher weight to this company’s sale value when calculating the average sale price.

METHOD 3 – Determine Market Value Using Multipliers

The most appropriate method for valuing a small business is the multiplier method. This method uses an income figure, such as gross sales, gross sales plus inventory, or net profit, and multiplies it by an appropriate coefficient (multiple) to arrive at a value for the business. This type of estimate is best used as a rough, preliminary valuation method because it ignores many important factors in determining the actual value of a business.

APPLICATION

1. Source the necessary financial figures. 

Generally, valuing a business using the multiplier method requires annual sales figures, gross profit figures, net profit figures and the values of tangible assets and current stock.

2. Find the appropriate coefficient to use.

The coefficient (multiplier) used will vary based on the industry, the market conditions, and any special circumstances within the business. The reliability of the multiplier can be somewhat arbitrary depending on who you consult, however a market based figure can be obtained from your trade association or from a business broker/appraiser.

3. Calculate the value using the coefficient.

Once you find the financial figures needed and the appropriate multiplier, simply multiply the numbers to find an estimated value for the company. Again, keep in mind that this is a very rough estimation of market value.

Examples

• Imagine that the appropriate multiplier for mid-sized professional services business is estimated at 1.5 x annual revenues. If’ total revenues for the latest financial year are $1,400,000, then the multiplier method yields a business value of (1.5 * 1,400,000) or $2,100,000.
• If a niche manufacturing business is earning 1,000,000 as a clear net profit after interest and depreciation a suitable multiplier might be 3.5, creating a market value of $3,500,000. This value could change substantially based on variables such as market conditions, number of buyers, business location, manufacturing methodology, access to skilled employees and future market opportunities to name only a few.