How do you value a business?

Next step: Be clear on what you’re valuing 

It is also important to understand what it is that is needs to be valued – for example, are we interested in the whole business or a small shareholding? 

A company’s value can be expressed with reference to either its “equity value” or its “enterprise value”. The first of these, equity value, is a measure of the value attributable to shareholders as owners of the company and is typically what is required in most instances. Enterprise value, on the other hand, represents the value attributable to all investors i.e. inclusive of both debt and equity capital (and may form a step in a valuer’s calculations of equity value).

Overview of Valuation Methodologies 

Company appraisals can be carried out using several methods, taken either individually or in combination. All approaches however may be categorised under one of the following: 

• Asset-based approach 
• Market-based approach 
• Income-based approach

The type of approach that will be adopted will depend upon the nature of the company, the data at the disposal of the valuer, and certain other factors such as the target company’s trading history.  

Asset-based approach to company valuation 

Asset-based methods are arguably the most straightforward, at least conceptually, as these focus on the underlying assets within the business.  

An asset-based approach will typically refer to the net asset value (NAV) method. The NAV is obtained by subtracting the company’s liabilities from the market value or recoverable value of its assets (noting here that there may be subjectivity in determining what an appropriate amount should be for each balance sheet item).

While this approach may appear simple, it should be noted that its application is incredibly limited. For example, it does not adequately capture any of the ‘intangible’ value that a company may generate, such as through the value of a brand, protected intellectual property or general ‘goodwill’. Accordingly, its application should be focused on ‘asset-backed’ businesses (such as property investment companies or single-site hotels) where the underlying asset values may be reasonably estimated. It may also be useful for companies winding up, or as a cross-check for other valuations where the underlying recoverable asset value may act as a ‘floor’ to any valuation range. 

Market-based approach to company valuation 

A market-based approach will estimate business value by benchmarking the target company against certain measures observed in comparable businesses, or from trades in similar assets.  

For private companies, such benchmarks will most commonly be drawn from one of three sources: 

1. Benchmarks observed from transactions in comparable businesses that have occurred recently; 
2. Benchmarks drawn from current data concerning publicly listed comparable companies; or 
3. With reference to recent trades in the company’s own shares.  

A capitalisation (or multiple) of earnings approach is an example of a market-based approach. This takes a multiple from comparable market data and applies this to the corresponding financial metric of the subject business.  

This approach may consider the target company’s expected maintainable revenues, EBITDA (earnings before interest, tax, depreciation and amortisation) or net profit, amongst other metrics (depending upon the context). The multiple applied to this metric will be drawn from the market data but should reflect the risks of the business and of the receipt of the expected income that it generates – meaning that judgement will be necessary.  

Adjustments may also be made for differences in certain factors including asset quality, growth prospects, and marketability.  

Market-based approaches are very frequently used and are particularly useful as they allow the valuer to reflect wider market dynamics in drawing their own conclusions. However, as with all valuation approaches, there will be limitations. For example, any assessment of maintainable income levels will be subjective, and restrict the scope for application in high-growth businesses.

Income-based approach to company valuation 

An income-based approach estimates the value of a business or asset by considering the expected future economic benefits and translating these into their ‘present value’. This category of valuation approach is forward-looking, adjusting for the risk of achieving such returns by discounting them with reference to factors such as market return expectations, market conditions, and the relative risk of the investment.  

A discounted cash flow approach is the principal methodology for valuing a company under an income-based approach. Under this approach, as the name implies, future expected cash flows are discounted to their present value, with reference to a ‘discount rate’. This discount rate should reflect the required return of an ’informed party’ investing in the subject asset, or an asset with an equivalent degree of risk attaching to it. 

An income-based approach is particularly useful for companies: 

• That can reasonably forecast future cash flows, and 
• Where future economic returns may be a materially better indicator of value than historic results (for example in a high-growth business).

Conclusion 

As we have outlined, there is no single way to value a business: the way it may be approached should be driven by various factors – and wherever possible, use of multiple approaches should help to provide confidence in a valuation opinion. 

The variety of tools that a valuer may have to hand in making an appraisal is rather broad, in number as well as in complexity. The methods to be utilised will be a matter of judgement, but a good valuer should not rely on formulae alone: the ability to stand back and ‘see the wood for the trees’ – i.e. to check the output makes sense, given what is known – is vital. 

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