3 Methods of Company Valuation

There are a lot of methods used today to find the value of your company.

Whether you are thinking of selling your business, buying a company, or searching for a way to better present your company to investors, it is important to know the actual value of your company. This is a critical part of operating a business, and there are many methods of valuation that you can choose from.

Though the methods of valuation seem to be an easy way of finding your company’s value, there are a lot of things to consider. By disentangling the different parts, you would be able to get the value of your business accurately.

But how do you get an accurate view of your business? And where do you start? There are a lot of methods used today to find the value of your company. This article explains these and gives you a detailed look at the three main methods of valuation.

Company Valuation Methods

Before we can dive into the different methods of valuation, let us understand some basic reasons as to why we need a company valuation. From pitching your business to new investors or for distributing shares to your employees, a valuation is needed to find the exact worth of your company.

Here are the reasons why we need company valuation:

  • You may wish to add shareholders, or a shareholder may be leaving and looking to liquidate their shares. In this case, you would have to determine the share value through a company valuation.
  • You may be looking for equity or debt financing. In this case, potential investors would see what the business is worth before they invest in your company.
  • You might be thinking of selling your company. For this, you need to know the actual value of your business to get the most out of the deal.
The reasons can be many, but the value of your business is something that is important to know and depends on many factors, including the current state of the market, your business’s financial statements, and even what state you were incorporated in!

What are the three Common Methods of Company Valuation?

There are numerous ways to value a company, from looking into the cash flow to using discounting factors on yearly revenue. However, after you boil down these valuation methods, three common methods are generally accepted:

  • Asset Based Approach
  • Earnings Approach
  • Market Value Approach

three common methods of valuation

Asset Based approach

This method includes the addition of all the assets put into the business. The asset-based methods of valuation are usually done on a liquidation basis or a going concern. Let us understand the concept a bit better with the following explanation.

What is ‘Asset-Based Approach?’

This approach focuses on the fair market value (FMV), or the net asset value (NAV) of the company. calculated the total assets less the total liabilities to figure out the cost of re-creating the company.

The actual value in the asset-based approach to calculate the company valuation could be much higher than the sum of all the recorded assets of the business. Let us take for instance the balance sheet. The balance sheet may not always have all the significant assets like the company’s methods of conducting business and internally developed products.

This happens as only the records which the owner has paid for appear on the balance sheet. So, if there are other assets of the business, they are not recorded in the balance sheet.

In short, even though this method is common, it cannot be used alone as it would not represent the exact value of the company.

Then why do we have it and when is this method used? The following would give you an answer to this.

Adjusted Net Asset Method

The adjusted net asset method can be used when a company has been generating losses, is not operating or the company only holds investments or real estate. This is one of the methods of valuation that is utilized for getting the estimated value of the business.

Key points about the asset-based approach to company valuation

AspectDetails
Overview
  • Calculates the company's net asset value (NAV) by subtracting total liabilities from total assets at current market values

  • Formula: Total Asset Value - Total Liabilities = Net Asset Value (NAV)

  • Provides an estimate of the company's value based on the worth of its underlying assets
  • Process
  • Identify and value all tangible assets (real estate, equipment, inventory, etc.)

  • Value intangible assets (patents, trademarks, goodwill, etc.)

  • Adjust asset and liability values from book values to current market values

  • Deduct total liabilities from total asset value to get NAV
  • Use Cases
  • Useful for asset-heavy companies or those with significant tangible/intangible assets

  • Applicable when the company is facing financial distress, liquidation, or sale

  • Provides a more conservative estimate of value based on assets rather than future earnings potential
  • Pros
  • Straightforward and objective by focusing on assets' market values

  • Includes intangible assets often missed on balance sheets

  • Flexible to use market values instead of book values
  • Cons
  • Does not consider future earnings potential which may be significant

  • Subjective in valuing certain assets/liabilities at market rates

  • More costly and time-consuming than other approaches
  • Example for Asset Based Approach

    Let us get a better understanding of the asset-based valuation method by looking at an example.

    Green Tech is a fast-rising startup known for its software products that seamlessly integrate into everyday life, enhancing productivity, efficiency, and overall user experience.

    To understand things better, below is the unadjusted balance sheet of the company along with the adjustments made.

    Balance Sheet
    For the Year Ended Dec 31st ($)
    15/5/2024AdjustmentAdjusted 15/5/2024
    ASSETS
    Current Assets
    Cash and Cash Equivalents809,913-809,913
    Accounts Receivable609,202-609,202
    Total Current Assets1,419,115-1,419,115
    Non-Current Assets
    Startup and Organizational Costs721,880-721,880
    Intangible Asset-76,86176,861
    Total Non-current Asset721,88076,861798,741
    TOTAL ASSETS2,140,99576,8612,217,856
    LIABILITIES & EQUITY
    Current Liabilities
    Accounts Payable350,335-250,335
    Short-term Loans---
    Accrued Expenses57,000157,000
    Total Current Liabilities407,335-407,335
    Long-term Liabilities
    Long-term Debt150,000150,000
    Deferred Tax Liability75,00075,000
    Long-term liabilities225,000-225,000
    Total Liabilities632,335-632,335
    Stockholders' Equity
    Opening Balance Equity382,500-382,500
    Retained Earnings125,190-125,190
    Shareholders' equity800,000-800,000
    Net Income200,970-200,970
    Revaluation of Intangible Asset-76,86176,861
    Total stockholders' equity1,508,66076,8611,585,521
    TOTAL LIABILITIES & EQUITY2,140,99576,8612,217,856

    At this point, can get the shareholder’s equity value for the adjusted balance sheet.

     Before Valuation ($)After Valuation ($)
    Total Assets2,140,9952,217,856
    Total Liabilities632,335632,335
    Revaluation of Intangible Asset-76,861
    Total Stockholders' Equity
    (Total Assets – Total Liabilities)
    1,508,6601,585,521

    Thus from a balance sheet perspective, the Company is worth $1,585,521 after adjustments.

    Earnings approach

    This is another common method of valuation and is based on the idea that the actual value of a business lies in the ability to produce revenue in the future. There are a lot of methods of valuation under the earning value approach, but the most common one is capitalizing past earnings.

    What is ‘Capitalization of Earnings or Capitalizing Past Earning?’

    Capitalization of earnings is determined by calculating the NPV (Net present value) of the expected future cash flows or profits. The estimate here is found by taking the future earnings of the company and dividing them by a cap rate (capitalization rate).

    In short, this is an income-valuation approach that lets us know the value of a company by analyzing the annual rate of return, the current cash flow and the expected value of the business.

    This approach of the capitalization of earnings, being one of the conventional methods of valuation, helps investors figure out the possible risks and return of acquiring a company.

    Finding a Capitalization Rate

    Finding out the capitalization rate for a company includes knowledge of the different kinds of industries and businesses, as well as a significant amount of research. Normally, the rates used for small businesses are 20% to 25%, which is the ROI (return on investment) that every buyer looks for while choosing which business to acquire.

    As the ROI doesn’t normally include the owner’s salary, this amount has to be separate from the ROI calculations. Let us take for instance a small business that earns about $200,000 every year and pays the owner a FMV (fair market value) of $50,000. The remaining $150,000 is used as income for valuation purposes.

    As soon as all the variables are known, the calculation of the capitalization rate is obtained with a simple formula. The formula is operating income divided by the purchase price. At first, the thing to be determined is the annual gross income of the investment.

    After this, the operating expenses have to be subtracted to find out the total operating income. Then this value is divided by the investment’s/property’s purchase cost to find out the capitalization rate.

    Capitalization of Earnings Example

    Let’s take an example of a company that for the last ten years, has earned and had cash flows of about $500,000 every year. As per the predictions of the company’s earnings, the same cash flow would continue for the foreseeable future. The expenses for the business every year is about $100,000 only. Hence, the company makes an income of $400,000 every year.

    To figure out the value of the business, an investor analyzes other risk investments that have the same kind of cash flows. The investor now recognizes a $4 million Treasury bond that returns about 10% annually, or $400,000. From this, the investor can determine that the value of the business is around $4,000,000. This is because it is a similar investment concerning risks and rewards. This would be a method in determining similar investments for the value of a company.

    Key points about the Earning approach to company valuation

    AspectDetails
    FormulaBusiness Value = Annual Future Earnings / Required Rate of Return
    Growth AssumptionAssumes constant growth rate of zero for future earnings
    ComplexitySimpler calculation
    SuitabilitySuitable for mature, stable companies with consistent earnings
    Time HorizonFocuses on a single year's earnings
    Terminal ValueNot applicable

    Example for Earning Approach

    So, let us say that a company has a Net Cash Flow of $512,255 in the final year of the projection period.

    Net Cash Flow
    (Final year of the projection period)
    $512,255
    Weighted Average Cost of Capital (WACC)25.00%
    Terminal Growth Rate5%
    Value of Business$1.56M

    Terminal value is calculated as shown below:

    Net Cash Flow in the Final Year512,255
    Terminal Cash Flow537,867
    Discount Rate - Growth (25.00% - 5%)20.00%
    Capitalizing @17.5%2,689,337

    The terminal value is then discounted using a company’s Weighted Average Cost of Capital (21.15%) and added to the present value of the free cash flows.

    YearNet Cash Flow ($)25.00% PV FactorsPresent Value of Cash Flow ($)
    2024204,2560.82483168168,477
    2025263,9140.65986534174,148
    2026433,3660.52789227228,770
    2027467,4550.42231382197,413
    2028512,2550.33785105173,066
    Terminal Value2,689,3370.33785105908,595
    1,850,469
    Add: Cash and Equivalence809,913
    Less: Debt-150,000
    2,510,382
    Rounded2,510,000

    So, in the above example, the value of the business is $2.51M.

    Market Value approach

    The market value approach is another standard method of valuation and is done by comparing the company with other similar companies that have been sold in the market. It can be used to calculate the property’s value or as a portion of the valuation method for a closely held company.

    The market approach analyzes the sales of every similar asset, and adjustments made for the differences in quality, quantity, or size, regardless of which asset is being valued.

    Two of the significant methods of valuation under the market approach are:

    • The Guideline Public Company Method which uses the prices of similar companies publicly traded; and
    • The Precedent Transaction Method which uses the prices of related companies recently sold.

    The value of a property can usually be estimated by studying the comparables in the real estate industry, like the current properties sold, and which had similar features and size. Other things are the location, which also helps in letting us know the value of that property.

    When it comes to companies, investors usually check things like recent sourcing transactions (sales, mergers), industry, economic condition, and close in operations.

    When analysts and investors perform an analysis to determine the value of a company via the market approach, they should pay close attention to the revenue or sales figures. It’s important to choose companies with similar revenue or sales size.

    Key points about the market value approach to company valuation

    AspectDetails
    Definition
  • Values a business based on market prices of similar companies or transactions
  • Methods
  • Public company comparables

  • Precedent transactions
  • Public company comparables
  • Uses valuation multiples (P/E, EV/EBITDA etc.) of publicly traded comparable companies

  • Adjusts for differences between comparables and subject company
  • Precedent transactions
  • Uses pricing multiples from actual M&A transactions of comparable companies
  • Process
  • Identify comparable companies/transactions

  • Calculate relevant valuation multiples

  • Apply multiples to subject company's metrics
  • Advantages
  • Objective, market-based value estimate

  • Based on real pricing data, not projections
  • Disadvantages
  • Requires sufficient data on true comparables

  • Finding accurate comparables can be challenging
  • Suitability
  • Most suitable when there is ample data on comparable public companies or transactions in the same industry
  • Example for Market Value Approach

    Here is an example of how to compare different companies within the same industry. Let’s take the company Zen Corp and perform a comparable analysis.

    Company NameEV/REVQuick RatioCurrent RatioReceivables TurnoverAsset Turnover
    Virtus Investment Partners Inc4.343.1138.080.23
    Westwood Holdings Group Inc0.743.633.876.20.58
    WisdomTree Inc4.432.172.2310.570.37
    Manhattan Associates Inc14.151.241.25.311.38
    Model N Inc4.573.8844.50.5
    SPS Commerce Inc12.762.473.1312.450.65
    NCR Voyix Corp1.150.560.97.430.77
    Median4.432.4737.430.58
    Average5.822.442.677.750.63
    10th Percentile0.990.971.084.990.31
    25th Percentile2.751.711.725.760.44
    75th Percentile8.673.373.59.330.71
    90th Percentile13.323.733.9211.321.01
    Zen Corp3.00002.000018.00002.0000

    Based on the financial ratio analysis for Zen Corp, it has a good standing compared with the other comparable companies. Thus, the median EV/REV multiple was used at 4.43, times an expected revenue level of $500,000, resulting in a firm value of $2,215,000. If we take the expected sales of:

    Enterprise Value of Zen Corp$ 2,215,000

    Factors to Consider When Choosing the right valuation method for a company

    Choosing the right method for a company depends on several key factors; here, we summarize the factors in the table.

    How to Choose the right valuation method for a company?

    Nature of BusinessThoroughly analyze the company's industry, growth stage, asset composition, and earnings stability.
    PurposeDetermine the reason for valuation, such as raising capital, mergers and acquisitions, or internal planning.
    Availability Of DataEvaluate the availability and quality of financial data required for different valuation methods.
    Industry StandardsResearch the valuation methods commonly used in the company's industry and for similar businesses.
    Choosing ProfessionalsConsult with valuation experts, investment bankers, or M&A advisors, especially for complex valuations or transactions.
    MethodsUsing a different method can give a more comprehensive and accurate valuation, particularly for complex businesses.

    FAQs

    This FAQs section answers your top questions about the different methods used and provides a basic overview of the topic.

    Which Company Valuation Method is Right for You?

    There isn’t a one size fits all type of company valuation, as there are many different methods for various companies. Out of all the methods, there isn’t one perfect method. Each has its own advantages and disadvantages based on various factors from industry valuation norms to the current economic market and interest rates.

    Can a company use multiple valuation methods simultaneously?

    Yes, a company can and often does use multiple valuation methods to determine its value. The significance of this approach lies in its ability to consider various perspectives. By triangulating the results from different methods, a company can arrive at a more robust and defensible, thereby mitigating the shortcomings of relying on any single approach.

    How does the choice of valuation method impact the accuracy of target prices for financial analysts?

    The choice of valuation method matters for target price accuracy; no single approach is definitively superior. Combining multiple methods can improve accuracy, but disclosure and rigor in the process may be more important factors influencing the precision of analysts’ target price estimates.

    What is the most commonly used valuation method by financial analysts?

    There is no one method that dominates, financial analysts tend to favor an eclectic approach, frequently combining DCF analysis with market multiples and potentially other techniques. The choice is influenced by factors like the company’s industry, growth prospects, and the purpose of the valuation. The research highlights the prevalence of using multiple methods rather than an overreliance on any single approach.

    Valuing Your Company Right with Eqvista

    At the end of the day, it doesn’t matter if you are planning to sell your business or not, it is always a good idea to have a comprehensive valuation of your business done. Having a thorough understanding of the economic aspects of your business would give you a clearer picture of your company, especially if you are looking for investors to fund your business.

    Eqvista’s valuation process leverages industry best practices and methodologies to provide accurate and defensible valuations tailored to each client’s specific needs. Their efficient online platform and team of experts streamline the valuation process, making it faster and more cost-effective compared to traditional methods.

    Interested in issuing & managing shares?

    If you want to start issuing and managing shares, Try out our Eqvista App, it is free and all online!