This comprehensive guide outlines how to value company or business entities for sale, the different methods, examples and the advantages and disadvantages of each method.
- How to value company or business entities: overview
- How to value company or business entities: From value to price
- How to value company or business entities: company valuation, purchase price and bank interview
- What is the included in the company value?
- How do I find reviewers who can help me?
- Business valuation methods
- The intrinsic value method
- How to value a company based on revenue or income
- How to value a business calculator
- The discounted cash flow method
- The multiplier method
- The venture capital method
How to value company or business entities: overview
The term “company valuation” is closely linked to the aspects of succession and company acquisition. Both are scenarios in which different parties with different interests meet. The negotiation of these interests is not infrequently like a game of poker: One party wants to sell its company, perhaps even its life’s work, for the best possible price. The other party wants to acquire a ‘valuable’ company that is profitable now and in the future. This is where both parties need to know how to value a company.
Both parties have one thing in common: they need a price for the company. A price that represents the company’s value for both sides. So the company that is to be sold or bought has to be valued. But how should the goodwill be determined by mutual agreement? After all, buyers and sellers have very different perspectives on the upcoming business: the selling side looks back at their efforts, the buying side looks expectantly into the future. So they will both look at the different methods for how to value a business, which we have outlined below.
How to value company or business entities: From value to price
You can already see that the terms company value and company price are closely related in terms of content, and yet it is worthwhile to make a clear mental distinction: the value can be determined using scientific methods based on certain assumptions, the price, on the other hand, is the individual negotiation result of the seller and buyer. In practice, the price can be above or below the calculated value. Value and price are not the same. But without value, there is no price to be found, so company valuation is an important step in buying a company.
In this guide you will find out which company valuation methods are available and which focus they each have. With all information and all technical jargon, keep in mind: A company valuation is always about strategic issues for which there is no fixed procedure. As a buyer or successor, you will soon ask yourself questions such as:
• How sustainable is the company that I want to buy or take over?
• How can I positively influence the company’s development with my know-how and network?
• Which risks are included in the transfer of ownership and how do I reduce and evaluate them?
• Will my motivation and enjoyment at work continue for the next few years?
And the choice of the evaluation method itself is a strategic question, because depending on the method, the company values that result from it can differ significantly.
How to value company or business entities: company valuation, purchase price and bank interview
If you are seriously considering buying or taking over a company, we strongly recommend that you study the subject of company valuation intensively. Even if the matter seems a bit dry at the beginning, it is important for you. As a (future) entrepreneur, you are responsible for yourself and your decisions – including the purchase price you pay. Also read how to register a business in the U.S. and what to consider.
Many founders rely on the bank’s assessment of the purchase price when exploring the right financing for the purchase. When granting the loan, the bank pays particular attention to the risk that the loan will not be repaid and not to whether the purchase price to be financed is a good deal for the buyer.
You should therefore intensively follow up on what is noticeable about the figures, what the banker’s assessment of the strengths and weaknesses of the company is and what its economic figures look like in comparison to the industry.
Therefore, focus on the viability of the existing business model. Ask yourself which adjustments will be necessary in the future and what influence the business model will have on sales and profits. We advise every buyer to describe the current business model in detail together with the seller and to make the opportunities for change and improvement clear.
Enough of the preface, now it’s time to get the concentrated information on company valuation so that you are well prepared for the takeover of a company.
What is the included in the company value?
A company valuation is used to determine the value of an entire company or part of a company. In addition to material values, such as land and machines, intangible values such as the brand and know-how of the employees are also assessed. Both the substance and the yield are taken into account. Individual factors such as industry affiliation and regional differences are also used for the assessment.
Various methods are available for company valuation. Which one is the right one depends on the respective company and must be assessed individually. The purpose of the evaluation plays a decisive role in the choice of procedure. Especially if you want to buy a small or medium-sized company, we recommend that you consult experienced experts when evaluating. Because practice helps here more than business theory. The expert will then determine the method that is most favorable for the particular case. Also read how to calculate working capital in a business.
How do I find reviewers who can help me?
Industry knowledge and experience are key when it comes to company valuation. If someone has a high level of expertise in an industry and perhaps already accompanied sales or at least knowledge of the usual market prices, that helps immensely. Such an expert does not necessarily have to be an expensive company pricing specialist.
• Inquire at your local bank for employees who specialize in your industry and on succession issues. With the bank, you have someone on board for the later financing and you can benefit from free advice.
• Another possibility: banks operating nationwide have their own competence centers for specific industries.
• The regional guarantee banks and chambers are also good contact points for evaluating business models and prices.
• Management consultancies with an industry focus can also accompany your purchase and support you with subsequent restructuring and optimization.
Business valuation methods
There are a number of business valuation methods, both in theory and in practice. There are quite a few procedures, and each one is not necessarily easy to understand. You can save yourself a lot of reading work if you do a few basic considerations:
• Would you like to buy a company that owns a lot of machines and / or real estate and whose success is not based on immaterial aspects? Then deal with the net asset value method.
• Are you interested in a company whose earnings can be easily forecast ? Then take a look at the capitalized earnings method and the discounted cash flow method.
• Above all, do you want to get a feel for the market situation and see whether you can even afford to buy a company at current market prices? Then read into the multiplier process. In practice, this method has emerged as the most relevant for company takeovers.
The intrinsic value method
The net asset value method is one of the clear and easy-to-understand processes for company valuation. This method assumes that the company is worth just as much as the sum of its parts. According to the net asset value method, the company value corresponds to the liquidation value, i.e. the market / market value of the company’s assets (equipment, inventories and other things) minus the debts.
The intrinsic value method is particularly suitable for setting a “minimum price”. The seller will not want to go below this price and you as the buyer will have to be prepared for the fact that the price will hardly be below the determined liquidation value. Also read about what exactly is business equity and debt to equity ratio.
As the sole method of determining value, the net asset value method is controversial, as it does not take into account the intangible assets and the future earnings position of the company. The net asset value method is particularly suitable as an auxiliary value for the valuation of small businesses with expensive machines or real estate.
Practical example for the net asset value method
Sole proprietor Martin (65 years) runs a small rented business, which he wants to sell to Steven due to his age. The profit from ordinary business activities before taxes in the past few years has been around $ 25,000 per year. As a salaried employee, Martin would earn around $ 30,000 per year.
The shop is not very profitable because Martin would have earned more as an employee. Since high profit increases are not expected in the future either, Martin and Steven come to the conclusion that although there is a customer base, no economic value can be assigned to them due to the low profitability of the shop. Since there is neither goodwill nor intangible assets, the company value is derived solely from the tangible assets. The lower limit for Martin is the liquidation value ($ 6,000), the upper limit for Steven is the reproduction value ($ 20,000). Martin and Steven agree on an average of 13,000 $ (= (20,000 $ + 6,000 $) / 2), since both contracting parties benefit in the same amount.
Advantages and disadvantages of the net asset value method
• Easy to use – no future forecasts necessary
• List of the replacement values of the tangible components of a company
• Important topics such as future viability, customer base, competitive situation are not taken into account
• The company’s profitability is lacking
• Figures for the replacement costs must be estimated or researched (via online portals)
Our verdict: This method makes sense to get a feel for a company’s inventory. As a basis for decision-making, this is only groundbreaking if machines and buildings etc. are the most important thing when buying. The result is then rather the lower limit of a purchase price. Also read how to pivot a business successfully.
How to value a company based on revenue or income
With the discounted earnings method, the company value is determined using the future income surpluses — the profit, in other words. And the methods for how to value a company based on profit takes into account the investment alternatives of the buyer. In this assessment, the perspective of an investor is taken who wants to invest his capital with interest and wants to pay a maximum of as much for a company as can be earned with it in the future.
Earning power and ability to service debt are essential in the case of a company succession, because the successor must not only make the investments required in the purchased company from the income, but also the interest and repayments from the purchase price financing.
The leading question of the how to value a business based on revenue method is: What can the company generate over the long term? The operating results before taxes for the last three years, the current financial year and the budgeted figures for the next few years are used. The company value is then determined in four steps:
- The operating result of the past is corrected for extraordinary and one-off expenses and income.
- The profit to be expected in the future is determined: The average of the corrected and planned operating results from step 1 represents the starting point for the profit to be expected.
- The capitalization rate is determined. This interest rate results from the interest that would be achieved with a risk-free investment and a premium for the entrepreneurial risk. For smaller companies and manageable risks, this rate is 15 to 20 percent. The higher this value is chosen, the lower the company value. The less predictable the future appears, the faster the buyer will want to have earned back the purchase price.
- The final earnings value is determined by dividing the expected future profit (from step 2) by the capitalization interest rate.
The how to value a business based on profit method is particularly popular with small companies. This process is available in different forms; from purely past-oriented to purely future-oriented. When choosing the capitalized earnings method, note that the profits of your predecessor are only an indication of your success. Chances are you’ll run the business differently than the salesperson – which is right – and that will also have an impact on the bottom line. Also not to be underestimated: The competitive situation and the economy can change over time.
Practical example for the income/revenue method
In the case study for the income value method, you can understand how this method is used for company valuation. A florist, Sally, determined the following figures in preparation for her company valuation. Due to a firm customer base and already concluded contracts, she expects an identical operating result in the next few years.
Step 1: Adjustment of the operating result:
Step 2: Determination of the profit to be expected in the future
(2,000 + 3,500 + 3,600 + 3,000 $) / 4 = 3,025 $
Step 3: Determination of the capitalization interest rate
For small and medium-sized companies, determining the risk interest rate is much more difficult. The use of standardized, capital market-related risk premiums is ruled out here. The owner dependency and company-specific risk factors, which continue to have an effect for a while after the sale, require an individual assessment. The lower the risk, the lower the interest rate. The risk premiums are usually between 5 and 15 percent.
Together with her advisor, Sally rates the risk interest at 9 percent. The calculation of the interest rate for long-term government bonds resulted in 2.32 percent. The capitalization rate is therefore 11.32 percent (= 2.32 + 9 percent).
Step 4: Determination of the final earnings value
3,025 $ / 11.32 * 100 = 26,722 $
Put in words, this result means: With a purchase price of $ 26-27 thousand and profits that do not change, I need a little more than 11 years to get my invested capital back.
Advantages and disadvantages of the discounted earnings method at a glance
• Focus on profit including executive salary
• Easy to calculate
• The design forms can be adjusted with regard to the importance of past and future data: high capitalization interest rate means uncertain future prognosis
• The subjective choice of the capitalization rate has a great influence on the result
• Winnings of the predecessor are of limited significance
Our verdict: This method makes sense to get a feel for the profit situation and the question of how many years it will take to earn back the purchase price if the situation remains the same. Unfortunately, this question is quite theoretical, because something always changes – and especially in the handover.
How to value a business calculator
As an early step, you can use the easy (although not always absolutely accurate) method: the how to value a company calculator.
This allows you to calculate company value roughly with an online tool, to give you an idea of the ballpark figure. Calc XML has developed an online business valuer tool with which you can evaluate a small or medium-sized company using the capitalized earnings method. With the tool you can get an initial result. It is free to use and no personal data is collected.
The discounted cash flow method
The discounted cash flow method (DCF method for short) has become more and more popular in recent years for calculating company value and is also internationally recognized. It is basically the same as the capitalized earnings method: A surplus is discounted to the present value (= discounted). In contrast to the discounted earnings method, the future cash flow is used in the DCF method.
In principle, a cash flow is understood to mean the comparison (offsetting) of deposits and withdrawals within a certain period of time . In practice, the number is determined from the bookkeeping. Depending on the method, the exact calculation is slightly different and there are libraries full of cash flow definitions.
The most important difference to the tax-effective profit (annual surplus) is the position “Depreciation”: If you buy a machine for 10,000 $, for example, the money may be withdrawn from your account in one fell swoop. From a business point of view (and thus also from a tax point of view), however, you use the machine for a certain period of time (e.g. ten years) – that is why the annual financial statements include a charge of $ 1,000 for ten years (depreciation).
As a result, the annual surplus falls – and gives the wrong picture of the company’s value, because the money for the machine was earned. The discounted cash flow method is not about tax logic, but about the company’s ability to self-finance – that is the core message of this process. Therefore, depreciation must be added.
Once the cash flow has been determined, it is usually extrapolated for three planning years for the discounted cash flow method and discounted to today’s capital value.
The discounted cash flow method focuses on the future development of corporate earnings. The discounted cash flow process is therefore a purely future-oriented process. And here one of the greatest challenges of the process becomes apparent: forecasts are made about the future development of a company and their accuracy decreases with increasing foresight.
Advantages and disadvantages of the discounted cash flow method at a glance
• Focus on the company’s self-financing power: not how much profit, but how much money is being earned?
• Numbers are available in the company
• The design forms can be adjusted with regard to the question of how important past and future data are: In this way, if the future forecast is uncertain, you can take a high capitalization rate and thus compensate for it
• The subjective choice of the capitalization rate has a major impact on earnings
• Previous results are of limited relevance for the future
Our verdict : The discounted cash flow method is particularly suitable for companies that have existed in the market for a long time and that have continuous growth as well as steady increases in profits and a certain size. The method is hardly suitable for small companies with high fluctuations and a poorly systematic growth strategy.
The multiplier method
The multiplier method is a market-oriented, practical method for company valuation. The value of the company is derived using ratios. The multiplier results from the realized market value, i.e. the sales price of a comparable company, in relation to the turnover or profit of the company up for sale. Once this factor has been determined, it is multiplied by the forecast earnings before interest and tax (EBIT).
There is also the indication of multipliers in relation to the turnover of a company. This is helpful for assessing the value of companies that are no longer making a profit after interest (you remember from school: 0 multiplied by X remains 0) or when the seller has not yet disclosed any earnings figures.
In order to select the right multiplier, it is important to use the right comparison group based on industry and size. So-called multiples tables, which indicate minimum and maximum multipliers for industries, help here. If you use these multipliers, you can determine the price range that is currently being called up for the majority of companies for sale in the respective industry. In individual cases, the price can also be outside this range. Always pay attention to the specifics of the company you want to buy. Ask yourself:
• How strongly does the company’s success depend on the owner compared to the competition?
• Does the company’s success depend comparatively heavily or less heavily on individual customers?
• Does the company that I want to buy have unique selling points and differentiating features from the competition?
• Is the growth potential comparable to the competition or does the company deviate (strongly)?
Practical example of the multiplier method
Let’s work this out with an example. Let’s say you want to buy a company with sales of $ 20 million in the food and beverages industry. In this case, you will come across multipliers of 4.4 to 6.5 for sales.
So you calculate for the “minimum price”:
Turnover $ 20 million × factor 0.95 = company value of $ 19 million
So you calculate for the “maximum price”:
Turnover $ 20 million × factor 1.32 = company value of $ 26.4 million
Interest-bearing liabilities are to be deducted from the enterprise value. Cash that is not required for operations is added.
The same company generates an EBIT of $ 0.3 million.
So you calculate for the “minimum price”:
EBIT $ 0.3 million × factor 7.5 = company value of $ 2.25 million
So you calculate for the “maximum price”:
EBIT $ 0.3 million × factor 9.5 = company value of $ 2.85 million
Interest-bearing liabilities are to be deducted from the enterprise value. Cash that is not essential to operations
The fact that the results from the sales-related and EBIT-related accounts differ so much shows that the company earns below average for this industry. So you will try to buy above the earnings value Don’t be surprised that the salesperson would like to talk about the sales multiplier. An industry estimator of the multipliers was published last year, with these estimates. However, there are other factors that can influence the multiplier, such as location, national economy, consumer spending habits, et.
|Field||Sales multiplier||EBIT multiplier|
|Commerce and e-commerce||0.58||0.91||6.5||8.8|
|Transport, logistics and tourism||0.50||0.80||6.0||8.0|
|Electrical engineering and electronics||0.68||1.00||6.6||8.6|
|Vehicle construction and accessories||0.58||0.88||6.0||7.9|
|Mechanical and plant engineering||0.70||1.00||6.8||8.2|
|Chemistry and cosmetics||0.95||1.30||7.6||9.5|
|Textile and clothing||0.70||0.97||6.2||7.9|
|Food and beverage||0.95||1.32||7.5||9.5|
|gas, electricity, water||0.70||1.00||6.0||7.8|
|Environmental technology and renewable energy||0.72||1.06||6.6||8.2|
|Construction and craft||0.50||0.77||5.4||7.2|
It is more individual, but also more labor-intensive, to speak to your house bank, tax advisor or other valuation experts and thus try to find a valuation that is suitable for the individual case.
Advantages and disadvantages of the multiplier method
• Based on the market price – what is currently being paid for comparable companies?
• Rough industry fit easy to research and calculate
• Simple implementation
• Can also be used in the case of a lack of earnings figures and unprofitable companies
• Does not take into account the company’s profitability, earning power and growth potential
• Difficult for smaller companies to determine meaningful multipliers
• After researching the industry-specific multiplier, it remains open and debatable:
How appropriate is it really?
Our verdict: This method helps to get an initial order of magnitude of what is paid for a company in an industry. The better the source situation and the fit to your own company, the more meaningful the result will be. In addition, the method is so understandable and widespread that buyers and sellers will know it.
The venture capital method
The methods for company valuation presented so far use sales or profits of one or even several years. These methods reach their limits in young companies and companies with no stable profit: Startups tend to have little capital, but have high growth potential; Much of the company’s assets are intangible assets. Often there is simply no cash flow. This is where the venture capital method comes into play, which is particularly used when evaluating startups. This method combines the discounted cash flow method with the multiplier method.
The venture capital method is based on the assumption that companies develop in phases. It starts with the seed phase, followed by the startup phase, the growth phase and the maturity phase. Usually no positive cash flow is achieved in the first two phases. This usually changes from the growth phase onwards, where the income value method and the discounted cash flow method can be used. The multiplier method is an option for the seed and startup phases.
Now to the venture capital method: With it, the buyer or investor perspective is taken upon exit. A possible price is calculated in the event of a future sale. The evaluation is carried out on a key date, taking into account the duration and risk of the investment. Here, the aspects of expected return, time required to exit and the company’s liquidity requirements are considered. This information results from the business plan, supplemented by some empirical values from comparable companies:
• Liquidity requirements
• planned turnover in x years
• Planned earnings before interest and taxes (EBIT for short) in x years
• industry-standard multiplier
• return expected by investors
The venture capital method is often used to value companies that are growing rapidly but are not yet profitable and are therefore difficult to forecast.
Advantages and disadvantages of the venture capital method
• Allows purchase prices to be calculated despite missing profits and still changing sales
• Complex – hardly comprehensible for people who are not familiar with such reviews
Our verdict: important for fast-growing startups in the early years. Not useful for normal small businesses and established medium-sized companies.
The choice of the right purchase price determination method can be controversial: past and future are compared, previous reality is compared with current and future market positioning. Assumptions are made that are shaped by subjective views.
Even so, a company valuation is essential when a company is being sold.
The available methods each have their advantages and disadvantages. Your results can vary widely. They are therefore not to be understood as exact values, but should be viewed by those involved as a range within which the final price can lie. We recommend that you use several methods.
The psychological component of a company valuation should not be underestimated either. Once the result of a company valuation is on the table, the elephant is in the room. Delaying the valuation is not an option either, because the price is ultimately decisive when taking over a company.
The greatest challenge and most important strategic decision in company valuation is to select the appropriate valuation method and to agree on it with the seller. With all the methods, procedures and formulas available, do not lose sight of the main questions and your motivation for taking over or buying a company and keep reminding yourself of the core of your project:
• What exactly do you get when you buy the company? Are you going to become the owner of machines? Do you own a promising product by purchasing it? Are you going to be the boss of a team that you enjoy working with and can imagine a successful future with?
• Does the purchase price feel good? Is there a relationship between price and “equivalent”? Material and immaterial risks are hiding somewhere – because when you buy a company, you are also taking over these from your predecessor. Here, too, listen to your gut instinct and not just to the advice of experts or to the numbers.
• Does the period in which your investment will have paid off is right for you? And: are you really ready to take the risk of buying a company?
• Do you trust yourself not only to continue running the company but also to make it “fit for the future”? Do you have a passion for entrepreneurship?
If you keep asking yourself these questions and answering them honestly, you will come to a good decision and also master the milestone ‘company valuation’ very well. Take on your project boldly and trust in yourself, your specialist and industry knowledge and your gut feeling. And if you need help and support, get it. No (evaluation) master has fallen from heaven yet and entrepreneurs do not have to make decisions without support.