Company Value: 5 methods for valuing your company

In-depth look at the main valuation methods for SMEs

Valuing a business is both an art and a science, and choosing the right method requires a deep understanding of the benefits and limitations of each. Let us thus take a closer look at the DCF method and the "multiple" business valuation.ternehmensbewertung genauer betrachten.

The "Discounted Cash Flow (DCF)"

The "Discounted Cash Flow (DCF)" method is a widely used business valuation methodology. It is based on the basic concept that the value of a company is essentially equal to the present value of its future cash flows. This method provides an in-depth insight into the economic performance of a company, but requires extensive data and detailed financial analysis = thus an overall complex and time-consuming methodology. The DCF method can be particularly useful when a company has stable and predictable underlying cash flows or is in an industry with few peers.

To use the DCF method, the following steps are required:

(1) Forecast expected cash flows: This requires forecasting expected cash flows over a specified forecast period, usually 3 - 5 years. These forecasts should be based on sound business planning and assumptions regarding sales growth, operating margins (development), investments, working capital requirements and tax rates.

(2) Discounting of cash flows: Future cash flows are discounted to their present value to determine the current value of the business. For this purpose, the discount rate is used, which is usually determined by taking into account the company-specific weighted average cost of capital ("WACC"). The WACC reflects the weighted average of the individual equity and debt capital costs of the company.

(3) Determination of the enterprise value: The discounted cash flows plus a so-called going concern value, residual value or terminal value are added together to determine the total value of the enterprise. Because the DCF valuation cannot take free cash flows into account ad infinitum, we usually make do with a simplification via the so-called "terminal value"), which represents the enterprise value after the cash flow projection phase.

The DCF method allows for a dynamic valuation as it takes into account changes in cash flows over time and the monetary present value. However, it is important that the assumptions and projections are careful and realistic in order to achieve results in line with the market. When using the DCF method, it is advisable to consult a professional such as an accountant, business consultant or valuation expert to perform an accurate and reliable business valuation.

The "multiple" company valuation

Alternatively, the "multiple" company valuation offers a quicker and tend to be simpler method of determining the value of the company.

The "multiple" company valuation or "market multiples" analysis uses sector-specific comparable companies to provide a benchmark for the valuation. Financial ratios and multiples, such as the price-earnings ratio (P/E) and the price-sales ratio (P/S), are used to derive the value of the company being valued. Typical multiples include the P/E ratio, which divides a company's share price by its earnings per share, or the CUV, which divides a company's share price by its sales per share. In order to obtain the best possible comparative results, the peer companies should have similar business models, growth rates, risk profiles, company size as well as market conditions relative to the company being valued.

The "market multiples" analysis uses ratios or "multiples" that are derived from the comparison with the most similar industry peers. The most common "multiples" are "EBIT" (= earnings before interest and taxes), "EBITDA" (= earnings before interest, taxes, depreciation and amortisation) or turnover. The use of turnover multiples is typically applied when more traditional valuation multiples (would) lead to negative valuation results, for example when a company is currently not generating any or only low profits. The "multiple" company valuation is particularly suitable for industries or companies where sales growth and market share gains are initially more important than short-term profitability. The accuracy of this method depends on the availability and quality of comparative data, so it is particularly suitable when there are many similar companies with available comparative data in the industry.

The choice between the DCF method and the "market multiples" analysis depends on several factors, including the availability and quality of the data needed, the complexity of the company and its industry, and the specific objectives and needs of the underlying company. Both methodologies contain strengths and weaknesses. The optimal methodology often depends on the specific situation of the company. It is important that companies understand both methodologies and choose the one that best addresses their specific needs and objectives.

Other methods available to choose from to value a company are:

The net asset value method

It is based on the premise that the value of a company is determined by the sum of its net assets. The net assets are calculated by subtracting the liabilities from the book value of the collected assets. The valuation of the assets can either be based on the book value or take into account the market value of the individual assets. The net asset value method is particularly relevant for companies with significant tangible assets such as real estate or equipment.

The capitalised earnings method with multiples

This method combines the capitalised earnings method with multiples to derive the enterprise value. The multiplier is usually derived from comparing similar companies or transactions, using financial ratios such as the P/E ratio, the CUV or the price-to-book ratio. The multiplier is applied to the projected earnings, sales or book value of the company to determine the enterprise value.

The real options analysis

The real options analysis takes into account the flexibility and strategic options a company has. This methodology views the company as a collective of real options that allow future business decisions to be adjusted or changed.

The valuation is based on the estimation of future cash flows from these real options and their probability of occurrence. Real options may include, among others, investment projects, research and development, market entry strategies or other strategic decisions.

Application of the valuation methods in practice

The application of the respective valuation methods in practice can be illustrated by concrete examples. Let us consider two hypothetical scenarios:

First, a medium-sized manufacturing company that is considering a major investment in new machinery. To analyse the profitability of this investment, the company applies the DCF method. It forecasts the additional cash flows that could be generated by the increased production capacity and discounts them to today's value. The results of this analysis may be decisive for the investment decision. If the discounted value of the additional cash flows equals or exceeds the investment costs, the investment can be considered profitable.

Secondly, a tech start-up that is planning to launch a financing round and would like to determine its indicative enterprise value for this purpose. Due to the nature of its business model, the company does not have stable cash flows in its current development phase, which significantly affects the application of the DCF method. Instead, the Company applies the "multiple" business valuation by comparing its business with similar businesses in its industry that have been part of an M&A transaction or completed a financing round in close proximity in time. This method allows the shareholder group to quickly and efficiently estimate its enterprise value and thus establish a price indication for the company.

These examples illustrate that the choice of valuation method depends heavily on the specific circumstances and needs of the company. The DCF method may be an appropriate choice if detailed financial data is available and a thorough analysis is warranted. The "multiple" methodology, on the other hand, may be a viable option when a pragmatic quick assessment is needed and appropriately comparable data is available for this purpose.

It can be said, then, that business valuation is a critical tool for business strategy and value enhancement initiatives. It serves not only as a gauge of a company's economic health and growth potential, but also as a guide for strategic decisions, from investments and acquisitions to pricing and strategic planning. Choosing the right valuation method is a critical step on the path to business success.

In conclusion, there is one question: which method best suits your business? Imagine that choosing a valuation method is like perfectly tailoring a pair of suit trousers to fit the specific needs and goals of your business. Your starting position may require an in-depth analysis of business performance using the DCF method. Or a valuation using "multiples" may be appropriate to obtain a quick assessment for an upcoming transaction.

Regardless of the individual requirements, a company valuation that is as precise as possible is an indispensable step on the way to the success of your business. It is the key that opens wide the door to informed strategic decisions.

Let's take a look into the world of thought and ask ourselves a rhetorical question: What if you did not know the true value of your company? How could you then make investment decisions, set the price for your products or services or even plan your long-term strategy?

Business valuation is much more than a mere financial metric; it is a strategic tool that helps you make informed decisions and maximise the value of your business.

Proper valuation of your business is critical to ensure that you recognise true value, not just price. It is an investment in understanding your business that will pay off in terms of informed decisions and ultimately a higher business value.

The "Zumera Value Calculator" supports you in this. You can use it to calculate the value of your company as a sound basis for the start of an M&A sales process.