Business Valuation: A Step-by-Step Guide to Valuing a Company
Company valuation
Valuing a company is crucial for any significant business decision, whether it’s selling, merging, or raising capital. The value assigned to a company affects negotiations, investment opportunities, and growth plans. Understanding the various methods for valuing a company is essential to determining an accurate company valuation.
In this guide, we will demonstrate three key methods used to value a company: the Discounted Cash Flow (DCF) method, Comparable Company Analysis (CCA), and Asset-Based Valuation. Each method offers a unique perspective, providing insight into the company’s market value, future earnings potential, and tangible asset value.
Business valuation objective
Our goal is to estimate the value of a company using these three methods. We will value a hypothetical manufacturing company, combining the results from each method to determine a final company valuation that reflects its true worth.
To dive deeper into the topic we encourage you to go to our article How to Value a Business: Understanding Its Importance and Methods of business valuation
Step 1: Assessing the value of a business
We are tasked with valuing a mid-sized manufacturing company. The company operates in a stable industry, has consistent future cash flows, owns significant assets, and competes in a mature market. These attributes make it suitable for using multiple corporate valuation methods, including DCF, Comparable Company Analysis, and Asset-Based Valuation.
Company Overview:
- Industry: Manufacturing
- Annual Revenue: $100 million
- EBITDA: $18 million
- Net Income: $12 million
- Assets: $120 million (book value)
- Liabilities: $30 million
- Discount Rate (WACC): 8%
- Projected Growth Rate: 2%
Now, let’s proceed with the corporate valuation process for this company using the three methods.
Step 2: Choosing a right valuation method
Company Valuation Using the Income Approach is widely used to estimate the intrinsic value of a company based on its future earnings. It is particularly effective for companies with stable and predictable cash flows, such as our manufacturing company.
Key Steps in the DCF Valuation Process
2.1 Estimating Future Cash Flows
The first step in the DCF method is to project the company’s future cash flows over the next 10 years (It could be less than that). For our company, we estimate it will generate $10 million per year in cash flows for the next decade, based on historical performance and market trends.
2.2 Determining the Discount Rate
Next, we determine the discount rate, which is the rate used to discount future cash flows back to their present value. The discount rate is based on the company’s Weighted Average Cost of Capital (WACC), which, for our company, is 8%. This reflects the company’s cost of equity and debt.
2.3 Calculating the Present Value of Future Cash Flows
To calculate the present value of each year’s cash flow, we use the following approach:
- In Year 1, the present value of the $10 million cash flow is:
$10 million ÷ (1 + 0.08)^1 = $9.26 million
- In Year 2, the present value is:
$10 million ÷ (1 + 0.08)^2 = $8.57 million
This process is repeated for each year’s cash flow over the 10-year period. The sum of the present value of all 10 years of cash flows equals $92.6 million.
2.4 Adding the Terminal Value
After calculating the present value of the projected 10-year cash flows, we need to account for the terminal value, which estimates the company’s value beyond the forecast period. We assume a growth rate of 2% to estimate the terminal value using the Gordon Growth Model.
The terminal value is calculated by multiplying the final year’s cash flow by one plus the growth rate, then dividing by the difference between the WACC and the growth rate:
$10 million × (1 + 0.02) ÷ (0.08 – 0.02) = $170 million
We then discount this terminal value back to its present value:
$170 million ÷ (1 + 0.08)^10 = $79 million
2.5 Total DCF Valuation
To calculate the total DCF value, we add the discounted cash flows ($92.6 million) and the discounted terminal value ($79 million). Therefore, the DCF valuation is:
$92.6 million + $79 million = $171.6 million
Using the DCF method, the value of the company is $171.6 million.
Step 3: Value a company using different business valuation method
The next method we will use is Comparable Company Analysis (CCA). Company Valuation Using the Market Approach estimates the company’s market value by comparing it to similar companies within the same industry. The assumption is that companies with similar business models and financial profiles should have comparable market values.
Key Steps in Comparable Company Analysis
3.1 Identifying Comparable Companies
First, we identify three publicly traded companies in the manufacturing sector that are similar in size, revenue, and business model to our company. These companies serve as our comparable companies.
3.2 Calculating Valuation Multiples
We calculate the corporate valuation multiples for these comparable companies. Common valuation multiples include the Price-to-Earnings (P/E) ratio and Enterprise Value-to-EBITDA (EV/EBITDA) ratio. After reviewing the data, we find that the average P/E ratio for these companies is 12x, and the EV/EBITDA ratio is 8x.
3.3 Applying the Multiples to Our Company
We then apply these multiples to our company’s financials. Given that our company has an EBITDA of $18 million and a net income of $12 million, we can calculate the market value using the following approach:
For the Enterprise Value (EV):
$18 million (EBITDA) × 8 (EV/EBITDA multiple) = $144 million
For the Market Value:
$12 million (Net Income) × 12 (P/E multiple) = $144 million
Thus, based on the Comparable Company Analysis (CCA), the market value of the company is approximately $144 million.
Step 4: Value a business basing on its assets
The third method we will use is Asset-Based Valuation, Company Valuation Using the Asset-Based Approach focuses on the value of a company’s assets minus its liabilities. This method is especially useful for companies in industries like manufacturing, where physical assets such as factories and machinery represent a significant portion of the business’s value.
Key Steps in Asset-Based Valuation
4.1 Assessing the Value of Assets
The company’s balance sheet shows that it owns significant physical assets, including manufacturing plants, equipment, and raw materials. The book value of these assets is $120 million.
4.2 Subtracting Liabilities
To calculate the net asset value, we subtract the company’s liabilities from the total asset value. In this case, the company’s liabilities, including debts, amount to $30 million.
Thus, the net asset value is:
$120 million (Assets) – $30 million (Liabilities) = $90 million
Using Asset-Based Valuation, the value of the company is $90 million.
Step 5: Comparing the Results
Now that we’ve calculated the company value using three different methods, we can compare the results:
- Discounted Cash Flow (DCF) Method: $171.6 million
- Comparable Company Analysis (CCA): $144 million
- Asset-Based Valuation: $90 million
Analyzing the Differences
Each method reflects a different aspect of the company’s worth. The DCF method provides the highest business valuation because it accounts for the company’s potential to generate future cash flows. The Comparable Company Analysis offers a middle-ground valuation based on the market value of similar businesses, while the Asset-Based Valuation gives a more conservative estimate by focusing only on the tangible assets of the company.
Final Valuation Estimate
To arrive at a final business valuation, we can take an average of the three valuation methods:
($171.6 million + $144 million + $90 million) ÷ 3 = $135.2 million
Or we can assign different weights to each method, based on where the company’s value derives from. More about the value you can read in the article: Company Valuation: What Is a Realistic Value and Purchase Price?
Conclusion
Accurately valuing a company requires using multiple valuation methods to get a full picture of its worth. In this guide, we used the Discounted Cash Flow (DCF) method to estimate the intrinsic value of the company based on its future cash flows, the Comparable Company Analysis (CCA) to gauge its market value against peers, and Asset-Based Valuation to assess its net asset value.
