How to Value a Company
So you are wondering how to to value a company.
First the bad news: valuating a company is far from an exact science. But the good news is that there are a variety of factors and formulas that you can use to accurately value a company.
The Fundamentals on How to Value a Company
Whether you are buying or selling a business, you will want to make sure you understand the company’s fair market price. After all, you ultimately want to know that you realized the maximum value of your business investment.
To begin the discussion on how to value a company, there are two basic terms you should first understand:
- Intrinsic Valuation- Intrinsic valuation is the process of calculating the value of the company’s future free cash flows.
- Relative Valuation- Relative valuation, on the other hand, involves looking at the market value of the company in relation to similar companies and applying the market value to the company you are valuating.
How to Value a Company Relatively
Relative valuation uses the idea of “multiples,” a term you have no doubt heard from an investment banker or two. Multiples are an easy way to discuss the value, and they are used when describing the market’s perception of a company and the company’s future growth.
In other words, if you have two companies with similar value drivers, such as their growth rate, their discount rate, their tax rate and their ROIC, then their multiples should also be similar. Multiples are essentially used as an alternative to the hassle of projecting a company’s future cash flows and its present value.
Therefore, according to relative valuation, if you have two companies with similar prospects and operating characteristics, then their multiples should be the same. If not, then the company trading at a lower multiple will be essentially undervalued. Likewise, if a company is trading at a higher multiple, it is considered to be overvalued.
How to Value a Company Intrinsically
Intrinsic valuation, on the other hand, is often much more confusing. You can find numerous online formulas for calculating intrinsic valuation, although there is no exact formula. Intrinsic valuation, however, often involves using a stock’s book value, its P/E ratio and its dividend yield.
Other Concepts that Help Value a Company
Other valuation concepts commonly used by investment bankers to calculate the value of a company include:
- Equity Value – The equity value of a company includes the overall value of the shareholders’ interests, as well as the company’s market value and its market capitalization.
- Enterprise Value (also known as the Aggregate Value, Firm Value and Transaction Value) – The enterprise value is used in company valuation because it covers all forms of a company’s capital, including its equity debt and its preferred stock.
In addition, many investment bankers begin their valuation of a company by simply looking at the company’s balance sheet. If you know how to read a balance sheet, you can quickly assess the company’s assets and liabilities, and therefore, be able to accurately reflect how much the company would be worth if it were to be liquidated.
Lastly, it is always important to watch the leading economic indicators, such as interest and inflation rates, as these two factors can play an important role in how to value a company.