How to calculate the valuation of a company
How is the valuation of a company estimated, and which different valuation methods are there? Let's explore
Valuation of a company, simply put, is the process of determining the current worth of a business. Imagine your friend selling their lemonade stand; you wouldn't just hand them any arbitrary amount, right? You'd consider factors like how many cups they sell, the cost of supplies, and even their location to estimate a fair price.
Company valuation follows the same logic but on a much bigger scale. Company valuation methods are crucial for investors, business owners, and anyone wanting to understand the actual value of a company.
What is the valuation of a company?
The valuation of a company is a critical financial metric that ascertains the monetary worth of a business, reflecting its overall economic standing and potential for future growth. The company valuation process involves a comprehensive assessment of its assets, liabilities, earnings, and market position to determine its intrinsic value.
By assigning a numerical value to the business, company valuation is a fundamental tool for decision-making, influencing investment choices, mergers and acquisitions, and strategic planning.
How to evaluate a company?
Various company valuation methods exist to appraise a company's worth, each serving distinct purposes and offering unique insights. Some of these include:
Book value
The book value method determines a company's worth by subtracting its total liabilities from its total assets, resulting in the net bookkeeping value. This value represents the shareholders' equity and indicates the company's net worth from a historical cost perspective.
The formula for book value is:
Book Value = Total Assets−Total Liabilities
Let's consider an example of a company with:
- Total Assets: $500,000
- Total Liabilities: $200,000
Using the book value formula:
Net Bookkeeping Value=$500,000−$200,000=$300,000
In this example, the bookkeeping value of the company is $300,000.
Discounted cash flows
The discounted cash flow (DCF) method revolves around estimating the present value of a company's future cash flows by applying a discount rate.
Forecasts of future cash inflows and outflows are analysed, and the resulting figures are discounted back to their present value to reflect the time value of money. The DCF method offers a forward-looking perspective, acknowledging the inherent value of a company's expected future earnings.
Discounted cash flow formula:
DCF=CF1/(1+r)^1 +CF2/(1+r)^2 + CFn (1+r)^n
Where:
CF1 =The cash flow for year one
CF2 =The cash flow for year two
CFn =The cash flow for additional years
r=The discount rate
Let’s consider an example:
When a company invests in a new project or purchases new equipment, it typically uses its weighted average cost of capital (WACC) to evaluate the discounted cash flows (DCF). The WACC is a combination of the average rate of return that shareholders expect to receive and the cost of the company's financing.
To illustrate this, let's say your company wants to launch a new project. If your company's WACC is 5 percent, you will use 5 percent as your discount rate. Suppose the initial investment for the project is $11 million, and it is expected to generate cash flows over five years. You can then use the estimated cash flows to calculate the project's net present value (NPV).
| Year | Cash Flow |
|---|---|
| 1 | $1 million |
| 2 | $1 million |
| 3 | $4 million |
| 4 | $4 million |
| 5 | $6 million |
Discounted cash flow
| Year | Cash Flow | Discounted Cash Flow (nearest $) |
|---|---|---|
| 1 | $1 million | $952,381 |
| 2 | $1 million | $907,029 |
| 3 | $4 million | $3,455,350 |
| 4 | $4 million | $3,290,810 |
| 5 | $6 million | $4,701,157 |
The total of the discounted cash flows comes out to be $13,306,727. When we subtract the initial investment of $11 million from this value, we get a net present value (NPV) of $2,306,727. This positive number shows that the project has the potential to generate a return higher than the initial cost, which means the investment has a positive return.
Market capitalisation
Market capitalisation, referred to as market cap, provides a snapshot of a company's total equity value as perceived by the market. It is a simple yet powerful metric that considers the stock price and the number of shares available for trading.
Market Cap formula:
Market Cap= Current Share Price × Total Number of Shares Outstanding
For instance, if a company's IPO value is $100 million, it might issue 10 million shares at $10 per share or opt for 20 million shares at $5 each. In both cases, the resulting market cap at the IPO would be $100 million, illustrating how the number of shares and their pricing influence the overall market capitalisation.
Enterprise value
To calculate the valuation of a company using the enterprise value method, one needs to consider not only the market capitalisation but also factor in the company's debt, cash, and other financial components.
A firm's enterprise value is beneficial for assessing the actual cost of acquiring a business, as it reflects the total value an acquirer would need to pay, including assuming or repaying the company's debt.
The enterprise value of a firm formula:
EV= MC + Total Debt−C
Where:
- MC = Market capitalisation
- Total debt = Sum of short-term and long-term debt
- C = Cash and cash equivalents are a company's liquid assets but may not include marketable securities.
- Let’s take an example of a company with:
- Market capitalisation (MC): $50 million
- Total debt: $20 million (sum of short-term and long-term debt)
- Cash and cash equivalents (C): $10 million
Plugging these values into the formula, we get:
$50 million + $20 million−$10 million =$60 million
So, the enterprise value of the company is $60 million.
EBITDA
The EBITDA is another method to assess the valuation of a company. If a company doesn't report EBITDA, it can be calculated using figures from its financial statements. There are two different formulas for calculating EBITDA, with one formula using net income and the other operating income.
- EBITDA= Net Income+Taxes+Interest Expense+D&A or
- EBITDA=Operating Income+D&A
Where:
D&A=Depreciation and amortisation
Let’s take an example of a company:
A company has generated $100 million in revenue. It incurred $40 million in cost of goods sold (COGS) and had $20 million in overhead. The company's depreciation and amortisation expenses amount to $10 million, resulting in an operating profit of $30 million.
The interest expense is $5 million, yielding earnings before taxes of $25 million. With a tax rate of 20 percent, the net income equals $20 million after subtracting $5 million in taxes from pretax income. If we add depreciation, amortisation, interest, and taxes back to the net income, the company's EBITDA equals $40 million.
Present value of a growing perpetuity formula
The formula for the present value of a growing perpetuity calculates the current worth of an infinite series of cash flows that grow at a constant rate.
The formula is:
PV=C/ (1+r)1 + C/(1+r)2 + C/(1+r)3 ⋯= C/r
For example, If a company is expected to make $100,000 in the 10th year, with a cost of capital of 8 percent and a long-term growth rate of 3 percent, the perpetuity value will be:
Cash FlowYear 10 ×(1+g)/ r−g
=$100,000×1.03/0.08−0.03
=$103,000/0.05
=$2.06 million
Therefore, assuming a 3 percent growth rate with an 8 percent cost of capital, $100,000 invested in perpetuity will be worth $2.06 million in 10 years.