The valuation of the company – how to valuate an enterprise?

  • 16 April 2016
  • Iguana Studio
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In market practice we have numerous opportunities to valuate the company. The most popular are mergers and acquisitions, but knowing the value of the company is also important in the credit procedure, placing the company on the public market, family succession, organisation of a capital group and the building of motivation programs for the executive staff. So how to determine the business value properly? Which valuation method should be adopted for the company to reliably determine its value?

Property methods

Literature on the subject presents a number of classifications of valuation methods. Three key approaches in this area are property, income-based and comparative valuation methods. Property valuation methods are considered, from the historical perspective, to be the oldest, and the least complicated methods at the same time. In its basic version, the valuation of the company is based on the net asset value approximately equivalent to the business equity capital. In the broadened version, the assets, which are firstly included in the balance sheet values, are adjusted to the fair value, that is the value that corresponds to the current market value. This method, however, should only be used in manufacturing enterprises, in which machinery constitutes a major asset of the company. In addition, from the company’s point of view, all relevant assets should be brought to the market value. For this purpose the market transaction prices may be used, or a test for impairment may be performed in accordance with the IAS 36 or IFRS 5. Certainly, a part of the property valuation can be made in-house, some of its elements, however, should be deputed to a property assessor.

Income-based methods

The discounted cash flow method is both the most important and the most popular tool for the company valuation. However, this method makes use of the parameters that do not reflect the actual state accurately, yet it constitutes only a prediction of the future results and factors in the business environment such as interest rate, growth rate, financial structure, cash flows and many others. These values are often difficult to predict for public companies listed on regulated markets and much more uncertain for private companies. So how should the valuation with the income-based method be performed? The first stage is the precise forecast of future income of our company. Although some advisers create predictions for the next 5 or 10 years, at Blackpartners we believe that in the current economic situation it is better to make such predictions for no more than 3 years. Of course it depends on the specific company, yet at the moment, the business predicitions for more than 3 next years are more a divination than the actual budgeting. The next step is the estimation of the company costs. A common mistake is the extrapolation of historical cost and forgetting about changing ambient conditions, inflation, and most importantly, a development strategy that often defines the cost centres and their size. The next step is the adjustment of operational costs to the cash level, and thus including the depreciation, as well as changes in stocks, debts and receivables (i.e. working capital). All these should result in a pure cash flow which will be implemented in our company.
Thereafter a discount rate should be defined, that is a rate that reflects the current value of the future cash flows. The most commonly used approach is WACC, a weighted average cost of capital in the company. It should be kept in mind that equity capital also “costs” and costs usually more than the foreign capital, which should be accounted for in the calculations. The final step is determining the residual value. It is the future value of the entity defined at the end of the projection of cash flows. Careful consideration should be given to determination of the residual value, since it assumes the endless cash flow in a company. In many cases the residual value is a major component of the company’s value.

Comparative methods

The essence of the comparative methods is the assumption that the financial market provides the best information for the valuation of companies. To this group belong first and foremost, the methods of market multipliers and comparable transactions. The first method is used in cases where the information comes primarily from the stock market, which is characterized at least by the average liquidity. On the other hand, the comparable transactions are used with regard to data derived from non-regulated securities market. It is important that both methods can make use of the indices designed in the same way.

When the valued company is not listed on the stock exchange, the method of comparable transactions is applied. It is used to determine a multiplier based on past transactions relating to undertakings similar to the one concerned.

An important limitation of this method is the difficulty in finding market transactions which could be considered similar. Important aspects in this case are especially the size of the company and the resulting economy of scale or the structure of assets and liabilities. These factors, specific to individual companies, may have significant importance from the fair and credible valuation’s point of view.

The market multipliers method is one of the most commonly used methods in the case of companies listed on a regulated market, since all necessary data are provided by the capital market. It consists in determining the company’s value through the so-called valuation basis and market multiplier. The following economic parameters can serve as a basis: net income, EBIT, EBITDA, the company’s book value, sales value, or the amount of cash flows to shareholders.

Which method should be chosen?

There is no simple answer to this question. Most advisers provide valuation service usually based on all three methods, specifying the weight for each of them. The weight of the individual method depends on the company’s size, type of business, industry, history and many other factors.

Artur Stypulkowski

The author is a consultant in our company.

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