Corporate valuation answers the question of how much a company is worth. There are standard ratios, tools and methods used by financial analysts to determine a corporations’ worth and whether their stock is undervalued or overvalued. Knowing this is very important when it comes to mergers, acquisition, financial stress and market instability.
The Common Method
One of the most common ways to determine the value of a company is called the asset-based method that uses the book value of a company’s equity. In other words, it determines the value of the company’s assets minus its debts. Regardless of whether it’s tangible items, such as cash and working capital, or intangible things, such as brand name and reputation, equity is the most important factor. Equity is everything that a company possesses if they were to suddenly stop doing business and making money.
Most accountants prefer to use the traditional balance sheet method. This is an excellent way to quickly determine if a company has more cash on hand than their current market value. First, accountants examine a company’s cash, equivalents and short-term investments. They divide the total number by the number of outstanding shares to measure how much of the current share price consists of just available cash. When it comes to buying a company primarily through cash, this yields a variety of benefits for the new owners. For example, cash can quickly fund strategic acquisitions, product research and development and the costs of acquiring successful executives and business leaders.
Another popular accounting measure of value is a company’s current working capital compared to its market capitalization. Working capital is defined as what remains after the current liabilities are subtracted from its current assets. Working capital are funds that a company can quickly access to conduct daily business transactions. Knowing the accurate amount of working capital is essential for businesses that trade and invest. Alternatively, shareholder’s equity is an accounting tool that encompasses a company’s liquid assets such as cash, property and retained earnings.
Shareholder’s equity is an overall measure of the liquidation potential a company has if all of their tangible assets were sold. Shareholder equity helps accountants to value a company when they want to establish the book value, which is official value of the accounting ledger. In order to calculate the book value per share, accountants divide the shareholder’s equity by the number of outstanding shares. Then, they divide the stock’s current price by the book value and find out the price-to-book ratio.
Free Cash Flows
Although most investors don’t understand the principles of cash flow, it is one of the most common measurement tools for valuing public and private companies in the field of investment banking. Cash flow refers to the money that passes through a company minus all fixed expenses during the course of a period of time, such as a quarter or the year. Cash flow is officially defined as the company’s earnings before interest, taxes, depreciation and amortization. Cash flow focuses on the business operations and not on secondary costs or profits. To illustrate, taxes depend on the current taxation regulations in a given year and can dramatically fluctuate.
When it comes to corporate valuation, keep in mind that intangible assets like goodwill and brand loyalty have value, but they cannot be quantified.
Value of Operations
Your company has a current value based on how it has been performing. To find that value, find your cash flow and multiply it by (1 + your current growth rate). For example, if your cash flow is $200,000 and your growth rate is 5 percent, you multiply 200,000 times 1.05 to get $210,000. Divide that figure by your cost of capital minus the growth rate. So, if capital costs you 12 percent, express this as .12 and subtract .05 to get .07. To finish the calculation, 210,000 divided by .07 is 3,000,000. Your value of operations is $3 million.
Present Value of Growth Opportunities
If you are buying more assets or another company, you can calculate how much more income that purchase will bring you annually. This growth can be added to your company value. Your growth opportunities also include any initiatives you are undertaking, such as an e-commerce effort, global marketing or adding new product lines, to give a few examples. Find the present value of your growth opportunities by using your present value of operations and subtracting earnings divided by cost of capital. In the example we’ve been using, if your current value of operations is $3,000,000, and earnings on equity are $100,000, with a 12 percent cost of equity, perform this calculation: 3,000,0000 minus (100,000 divided by .12). Your present value of growth opportunities is $2,166,667.
You may have assets that don’t contribute to operations. Non-operating assets include investment accounts, bonds, cash that is earning interest and any real estate you own that is not directly used as part of your operation. To determine value, you have to use a snapshot of the cash value at the moment you are doing the calculation. Clearly, this type of asset can fluctuate in value. Nevertheless, if you value non-operating assets at the same time each year, you will have a fair idea of their value and how they contribute to your overall valuation.
Goodwill and Brand Value
If you have a strong brand and a lot of customer loyalty, these intangible assets have value. There is no formula for establishing a dollar amount for intangible assets, but you can add a premium to your company’s value based on what similar companies in your industry have done. The basic idea is that your company is worth more because people trust it over your competition. You will have to estimate the value of this, but if you were to sell your company, the market would accept an educated guess about the value of intangible assets.
If management personnel are confident that they can’t be replaced and that they won’t be judged by performance, you may have to discount your company value because anyone buying your company might meet with resistance regarding price or even regarding whether to sell at all. In addition, those appraising the company may wonder if the business can innovate and grow if management has little incentive to do so. Such entrenchment is viewed as a negative when valuing a company, so take it seriously. A track record of turning down buyout offers and avoiding innovation can cause your overall valuation to decline.