What it means
Value matters whenever money changes hands or decisions are made about the future. A founder selling a company, an investor buying shares, a bank lending against assets and a board approving an acquisition all need an estimate of worth.
Valuation analysis gives a structured way to reach one. The three main approaches are the market approach, the income approach and the asset approach.
The market approach looks at how similar businesses or deals have been priced, the income approach values the cash a business is expected to generate, and the asset approach adds up what the business owns less what it owes. Analysts often use more than one method and compare the results.
A common market method uses multiples, which are ratios such as enterprise value to EBITDA (earnings before interest, tax, depreciation and amortisation, a measure of operating profit). If similar companies sell for six times EBITDA, a company earning $2,000,000 might be worth about $12,000,000.
The result depends heavily on choosing truly comparable companies. The income approach, usually called discounted cash flow, forecasts future cash flows and converts them into today's money using a discount rate that reflects risk.
It is flexible but sensitive, because small changes in growth or the discount rate can move the answer a long way. For this reason, analysts show a range and test different assumptions.
Valuation also depends on purpose. The value for a tax filing, a sale to a strategic buyer and a loan against assets can differ because the rules and the buyer's motivations differ.
A company with a controlling stake may be worth more per share than a minority holding, and shares that are hard to sell may carry a discount. For non-finance managers, the main lesson is to question the assumptions behind a number.
Ask what method was used, which comparable companies were chosen and what growth was assumed. A valuation is only as reliable as its inputs, which fits the principle that poor data in produces poor results out.
In practice
Real-world examples.
Example
A founder preparing to sell her software business asks an adviser to value it. The adviser compares it with recent sales of similar companies and also builds a discounted cash flow, then presents a range for negotiation. He also asks a second adviser to review the figures, since a fresh pair of eyes often finds assumptions that look too hopeful.
Example
A bank considers lending against a factory and orders a valuation of the building and machinery. It lends a percentage of the assessed value so it has a cushion if prices fall. The bank also asks for an updated valuation every year, because the value of the factory can change as markets move.
Example
A board reviews an offer to buy the company. Its advisers run a valuation analysis to judge whether the price is fair to shareholders. They also ask what happens to the value if sales grow more slowly than the plan assumes.
Formula
Calculation
Equity value = (EBITDA x valuation multiple) - net debt
Suppose a company earns EBITDA of $2,000,000 and similar businesses sell for 6 times EBITDA. The enterprise value is 2,000,000 x 6 = $12,000,000. The company has debt of $4,000,000 and cash of $1,000,000, so net debt is 4,000,000 - 1,000,000 = $3,000,000. The equity value is 12,000,000 - 3,000,000 = $9,000,000, which is what the owners' shares are worth under this method.Case study
Seen in the real world.
Moorfield Plastics is an illustrative, fictional manufacturer that receives a takeover approach. The buyer offers $10,000,000 for the shares, and the board asks its finance director to test the offer.
She values the company with two methods. A multiple of 6 times EBITDA of $2,000,000 gives enterprise value of $12,000,000, and after net debt of $3,000,000 the equity value is $9,000,000. A discounted cash flow gives a range of $8,500,000 to $10,500,000.
In this illustrative story the offer sits in the middle of the range. The board negotiates for a higher price and a payment partly in cash, because the analysis shows the offer is fair but leaves little room above the value of the business. She also records every assumption in a memo for the board, so that later reviewers can see how the numbers were reached.
Watch out
Common mistakes.
- Treating a valuation as a precise fact, when it is an estimate that depends on assumptions.
- Picking comparable companies that are not truly similar, which can distort a multiples valuation.
- Forgetting to subtract net debt when moving from enterprise value to equity value.
Questions
People also ask.
What are the main valuation methods?
The market approach, the income approach and the asset approach, which are often used together.
Why do valuations of the same company differ?
Because analysts use different methods, forecasts, discount rates and comparable companies, and the purpose of the valuation can differ.
What is the difference between enterprise value and equity value?
Enterprise value is the value of the whole business, while equity value is what remains for owners after net debt is taken off.
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