Investing your money is a big deal, especially if you are using most of your life’s earnings in this business. Buying an existing business is one way to invest your money in something. Suppose you are wondering how you will know if the amount you are paying for the business you are buying is a good reflection of its real value. Well, there’s a way to help you answer that. We will teach you how to value a business so you can determine the proper range of amount you should pay for a business.
Asset-Based Valuation
The first approach on how to value a business is the asset-based valuation approach. This approach uses the assets of a company to determine its value. Use this approach if you plan to buy companies with a lot of assets like real estate companies. If you plan to purchase tech startups and other companies with not a lot of assets, this one would be difficult to use.
The first thing you need to do to assess the value of the company using its assets is to acquire its balance sheets. It can also be called the statement of net worth since everything related to their finances should be included here. You can find here all the assets of the company and also all of its liabilities.
After you have acquired the company’s balance sheet, add up all of its assets. Now you might think that this is the value of the company, but it’s not. As a buyer, you would want the lowest possible price for yourself. If you are the seller, of course, you would want the highest price.
The next step you should do is adjusting the assets. You can adjust the assets up or down to give additional value to a specific asset. Some assets may not be included in the balance sheet, and as the seller, you can add that asset if you think it has value. If you are the buyer, you can also adjust the value of some assets if you think they are overvalued.
Lastly, you also need to account for the liabilities to get the full company valuation. These liabilities will be passed on to the buyer, so they should also be part of the computation of the value of the company they are buying. Some liabilities like future legal liabilities are not reflected on balance sheets, and they can also be part of deciding the business valuation of a company.
One downside of this valuation approach is it depends heavily on the balance sheet of the company. If the balance sheets were updated a month or two ago, they would not reflect the real-time value of that business. It’s also hard to use this approach on businesses that don’t have many assets to begin with. Most internet companies cannot be valued using this since most of their value comes from their future valuation.
Ratio-Based Valuation
The next way on how to value a business is the ratio-based valuation approach. It is also called the multiples-based approach. To get the business valuation using this approach, you will need to check on other companies related to the business you are planning to buy.
Think of this way as buying a house and checking the prices of the house within the neighborhood to determine how much you should pay.
There are various multiples in which you can compute the value of a company, Price/Earnings Ratio, Price/Sales Ratio, and Price/Book Ratio. Price/Earnings Ratio or the PE ratio is the ratio between the total price of the company to its earnings.
The PE ratio of related companies will be your benchmark. To compute the value of the business, you will tweak the computation a bit. This will require some math.
For example, P/E is equal to 5. The estimated earnings of the company you are planning to buy are around 50 million dollars. You can interpret this as P/50 million equal to 5. To get P, we multiply both sides by 50 million. As a result, P or price is now valued at 250 million dollars.
The two other multiples work the same way as the PE ratio. It’s just that you are using a different value. the Price/Sales Ratio is for companies earns through sales of services like internet companies. Price/Book Ratio is more suited for companies that rely heavily on their assets for values.
This method gives you a very rough company valuation, and it might not be reliable for buying companies. It can work as a sensibility check if the resulting value of the other methods is near this estimation. This can also work as a stock price checker. If one company sells its shares lower than the resulting value in this method, that stock price might be undervalued.
Discounted Cash Flow Valuation
This approach on how to value a business works the same way as how you look at a property. The Discounted Cash Flow valuation approach or DCF calculates how much money you can earn from the company that you are planning to buy. It creates a forecast of how much the business can earn in the next few years. After computing that, you discount it in terms of today’s money.
Discounting is needed because money changes value over time. Money that you can get in the future changes its value over time compared to the money that you can get now. Another factor is inflation. Inflation lowers the value of money over time.
Another component of this business valuation method is the interest rate you will use for computing the discount of the earnings forecast. The interest rate depends on the risks connected with the business being talked about.
For example, you are buying a business, and we create the earnings forecast for the next 5 years. Our forecast shows that this company can earn up to 50 million dollars each year. The total would be 250 million, right? But that is still not our final value. If we have an interest rate of 10 percent, the discounted rate per year would be down to 91%, 83%, 75%, 68%, and 62%, respectively. Computing that would result to 45.5, 41.5, 37.5, 34, 31 million respectively and has a total value of 189.5 million dollars.
Since we cannot assume how long a business will last, we cannot forecast the whole existence of the business moving forward. One way to address this problem is by having a terminal value. This value is set as a lump sum of the estimated earnings of the company after the forecast duration. In our example, our forecast is up to five years after acquisition. We can set a terminal value to assess the company’s earnings after that.
This method relies heavily on the earnings forecast, so having a good financial expert do the forecasting is a good way to ensure getting a sensible price for the business you are planning to acquire.
Conclusion
Any business that we get ourselves into should be valued well. Anything that gives us earnings should be properly taken care of and valued. Now that you know how to value a business, you can now properly assess companies before you buy them. One last tip for any business dealings that you might have in the future: consult experts that can help you decide and hire professionals for accounting and auditing so that you will not have any misguided moves.