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.
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.
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.