Subtracting liabilities from assets is one method of determining a company’s value. This straightforward approach, nevertheless, doesn’t necessarily give the complete picture of a company’s value. Other approaches are available because of this.
Business Valuation Techniques
Six business valuation techniques are examined below: book value, discounted cash flow analysis, market capitalization, enterprise value, earnings, and the present value of a growing perpetuity formula. These techniques can all be used to assess a company’s financial health.
1. Book value
Calculating a company’s book value using data from its balance sheet is one of the easiest ways to determine its value. However, despite how straightforward it seems, this strategy is particularly unreliable.
Start by calculating owners’ equity by deducting the company’s obligations from its assets. This will give you the company’s book value. Afterward, take away any intangible assets. The sum remains is the worth of any tangible property the corporation possesses.
Due to historical cost accounting and the conservative principle, balance sheet numbers cannot be equated with value, as harvard business school professor mihirdesai points out in the online course leading with finance. Relying solely on fundamental accounting indicators fails to capture the underlying worth of a company.
2. Discounted cash flow analysis
Discounted cash flows are a different way to value a business. In leading with finance, this method is emphasized as the benchmark for appraisal.
The method of determining the worth of a business or investment based on the money, or cash flows, it is anticipated to earn in the future is known as discounted cash flow analysis. Based on the discount rate and analysis period, discounted cash flow analysis determines the present value of future cash flows.
Discounted cash flow is calculated as terminal cash flow divided by the number of years in the future (1 + capital cost).
Discounted cash flow analysis has the advantage of reflecting a company’s capacity to produce liquid assets. The difficulty with this sort of valuation is that its correctness depends on the terminal value, which might change depending on the future growth and discount rate assumptions you make.
3. Market Capitalization
One of the simplest ways to gauge the worth of a publicly listed firm is through market capitalization. By dividing the entire number of shares by the market price at the time, it is determined.
Share price times the total number of shares equals market capitalization.
Since most businesses are financed by a combination of debt and equity, one drawback of market capitalization is that it solely takes into account the value of stock.
In this instance, debt refers to bank or bondholder investments in the future of the company; these liabilities are repaid over time with interest. Equity is the term used to describe stockholders who have a claim to future profits and possess shares in the company.
Let’s look at enterprise values, a more precise indicator of corporate worth that accounts for these various capital arrangements.
4. Enterprise value
The enterprise value of a corporation is determined by adding its debt and equity, then deducting the sum of the cash available for operating capital.
Debt plus equity minus cash equals enterprise value.
Let’s look at three well-known automakers to demonstrate this: tesla, ford, and general motors (gm).
The market value of tesla was $50.5 billion in 2016. Additionally, its balance sheet revealed $17.5 billion in liabilities. Additionally, tesla had about $3.5 billion in cash on hand, giving the business an enterprise value of about $64.5 billion.
Ford had a $44.8 billion market capitalization, $208.7 billion in liabilities, and $15.9 billion in cash, leaving it with an enterprise value of roughly $237.6 billion.
Gm’s enterprise value was roughly $215.8 billion after taking into account its market capitalization of $51 billion, balance sheet liabilities of $177.8 billion, and cash balance of $13 billion.
Despite having a larger market capitalization than ford and gm, tesla is also backed with greater equity. In actuality, whereas ford and gm have capital structures that rely significantly more on debt, 74 percent of tesla’s assets have been financed with stock. Both 22.3 percent and almost 18 percent of ford’s and gm’s assets are funded with equity.
5. EBITDA
Financial experts prefer not to look at a company’s bare net income profitability when analyzing results. The traditions of accounting are frequently used to alter it in several ways, some of which even obscure the real picture.
The tax laws of a nation initially appear to be an impediment to a company’s actual success. Even if the company’s operational capabilities remain unchanged, they may change across nations or over time. Second, net income excludes interest payments made to debt holders, which can alter how successful a firm appears based purely on its capital structures. These factors are taken into account when adding both back together to get ebit, often known as “operating earnings.”
In typical accounting, a business doesn’t register a building or equipment purchase all at once. Instead, the company records a cost for itself called depreciation over time. For items like patents and intellectual property, amortization is the same as depreciation. Both times, no money is actually spent on the expense.
Depreciation and amortization may, in some cases, make a company’s earnings appear worse than those of one that is dropping. Due to their ownership of numerous warehouses and factories whose worth diminishes over time, behemoth brands like amazon and tesla are especially vulnerable to this distortion.
Investigating ratios is simpler after you know how each company’s EBITDA (earnings before interest, taxes, depreciation, and amortization) is calculated.
According to the capital IQ database, Tesla has an enterprise value to EBITDA ratio of 36x. Gm’s is 6x, and Ford is 15x. What, though, do these ratios indicate?
6. A growing perpetuity formula’s present value
These ratios can be considered as a component of the expanding perpetuity equation. A type of financial instrument known as a growing perpetuity pays out a specific sum of money each year, which increases yearly. Imagine receiving a retirement allowance that must increase each year to keep up with inflation. You may determine the current value of that type of financial instrument using the increasing perpetuity equation.
Divide cash flow by the cost of capital less the growth rate to find the value of a rising perpetuity.
Cash flow divided by (cost of capital – growth rate) is the value of a growing perpetuality.
Therefore, the present value of that agreement would be $375,000 if someone who was going to retire wished to receive $30,000 annually, forever, with a discount rate of 10% and an annual growth rate of 2% to account for anticipated inflation.
What is this related to businesses? Think of a company’s ebitda as a perpetual growth that is distributed to its investors each year. This equation can be used to rapidly calculate the enterprise value of a company if you can think of it as a stream of cash flows that grow annually and you know the discount rate (which is the cost of capital for that company).
You’ll need to convert your ratios using algebra to do this. For instance, if you take tesla as an example, its enterprise value is 36 times greater than its ebitda, or earnings before interest and taxes.
If you use ebitda as the cash flow in the rising perpetuity formula and enterprise value as the variable you’re trying to solve for, you’ll know that whatever you divide ebitda by will result in a result that is 36 times the numerator.
Use this formula to calculate the enterprise value to ebitda ratio: ebitda divided by one over ratio is equivalent to enterprise value. To find the ratio, enter the enterprise value and ebitda numbers.
Enterprise value is equal to EBITDA divided by one.
In other words, the denominator must be 13.6 percent (or 2.8%). If you were to apply this example to ford, the denominator would be one-fifteenth, or 6.7 percent. It would equal one-sixth, or 16.7 percent, for gm.
The percentage is equivalent to the cost of capital when it is replugged into the original equation. Then you may speculate that tesla might have a 20 percent cost of capital and a 17.2 percent growth rate.
The ratio doesn’t tell you everything, but it does show that the market expects tesla’s growth rate to be near to its cost of capital in the future. Sales for tesla in the first quarter were up 69% from the same period in 2017.
