How much is a business worth? As you will see, the answer depends on who and why you ask?
Let’s begin with what may be termed the fundamental methods. Each of these methods will provide us with a value based upon financial data. They may be seen as offering a base point from which the value may go up or down depending on other factors which we shall discuss shortly.
For large publicly quoted companies it is possible to use the Price/Earnings (P/E) Ratio – the market value of the business divided by its post-tax profits or simply put, the share price divided by the earnings per share. If a company has a share price of $20 and earnings per share of $2, it has a P/E of 10. Multiplying the post-tax profits by 10 providers with the base value. For smaller, non-traded companies sector averages can be used as a guide.
Clearly this is a very simplistic approach. There are wide variations between industry sectors and many high-growth companies may not actually make a profit; Amazon traded for many years before returning a profit and had a market value of several billions of dollars. Earnings multiples may be used to provide a ‘sense-check’, although evidence suggests that investors can always justify nonsense when they want to.
Where there are significant tangible or easily realisable assets, these can be valued. There will generally be an analysis and revaluation of the balance sheet to take into account the actual market values of fixed assets, the liquidity of stock, the security of accounts receivables and so on. The net realisable value achieved in this way will be similar to the sum that could be raised by selling the assets.
How much would it cost to establish a similar business from scratch.
The other approaches provide alternative perspectives but it is the discounted cash flow or NPV approach that, in my opinion, provides the best base valuation. In principle, the calculation is: calculate the NPV for the forecast period and add the value of the balance sheet. This begs a number of questions:
Each party to a valuation, owner, investor, potential buyer etc, will have their own views and will arrive at their own valuation for the company. I am particularly looking at the situation where a business is being acquired since this brings into play other factors.
Value and worth are different concepts. I can value a company but it may not be worth that to you as a potential buyer. Its worth to you will depend on what you can do with it. Imagine that you would like to acquire the business as a going concern and integrate it with your existing business to achieve:
In such a case, the business is worth much more to you than its base value. If I, as the seller of the business know this, then I am likely to raise my price. And so the negotiation begins. Each side will be mindful of the wider context:
There is a balance of power, real and perceived. The value of a business is ultimately where a balance is struck between differing worths.
As a potential buyer it is important to look at the full incremental impact of acquiring versus not acquiring a business. Let me illustrate this. Imagine that you are acquiring chain of convenience stores. You already own several stores nearby. In evaluating the acquisition, it is not simply a question of valuing the future cash flows of the company you are acquiring:
The difference between the two are your incremental cash flows and it is these that should be discounted to achieve the NPV.
In reality there will be several scenarios that need to be calculated, particularly for the no acquisition route. What impact would it have on your cash flows if your major competitor acquired the other business. Or your target acquisition gained major new investment and decided to expand into your current market. Each scenario creates a different stream of incremental cash flows, but all are based on assumptions about the behaviour of other parties. As I mentioned earlier, the finance is the easy bit – the hardest part is deciding what the numbers should be that you use in the financial calculations.
As we have seen throughout the financial modules:
one must look beyond the numbers