Company Valuation: An Overview of 5 Methods for Determining Company Value

Company Valuation Methods: An Overview

The methods of company valuation are diverse and complex. Discounted Cash Flow methods, earnings value methods, asset-based methods, multiples ... and more. To determine which method will yield the best results for your company, you need the expertise of experienced M&A advisors.

Regardless of the method used, as a business owner and seller, you have already overcome the most significant hurdle in the business sale and succession planning process by engaging with the topic of company valuation.

Read on to discover the five common methods of company valuation available to you. Here, you can gain an overview of how these methods differ from one another and which method should be used when.

What is a Company Valuation?

A possible definition of company valuation could be:

A company valuation is usually conducted before a company sale. The company value determined in the valuation process serves as a basis for price negotiations. Various methods can be used to determine the value of a company.

The five most commonly used methods to determine a company's value are:

1. Earnings Value Method (EBIT = Earnings before Interest and Taxes)
2. Asset-Based Method
3. Median Method
4. Market Value Method
5. Discounted Cash Flow Method (DCF Method)

Why is the Value of a Company Determined?

When selling a company, at least two parties with different interests come together: sellers and buyers. Sometimes investors also play an important role.

While sellers naturally want to negotiate the highest possible price for their company, buyers often want to lower the price. To agree on a purchase price, the negotiating parties need to find common ground. This foundation is established through a company valuation.

Why Are There Different Methods?

Why are there different methods to determine this value? This is because sellers, often the original owners who may also be the founders, typically base the valuation on their past successes, profits, and the company's history.

Emotional factors also often play a role for them. Therefore, sellers may want to set a higher value based on gut feeling. This value is also known as sentimental value, ideal value, emotional value, or memory value.

Buyers, on the other hand, are more interested in the company's future. They consider not only the revenue of previous years and the machines currently in use but also the company's future possibilities:

• How much revenue and profit can be generated with the acquired company looking forward?
• What level of risk is involved in the project?
• How can employees and machines be prepared to achieve new plans?

To reach an agreement, different valuation methods must be used. This can create a pleasant, cooperative atmosphere at the negotiating table and result in an outcome that satisfies all parties.

What Role Do M&A Advisors Play?

Does the above scenario sound like something you want for your future company sale? To ensure your company sale goes smoothly in practice, not just in theory, start looking for an experienced M&A advisor early on.

M&A advisors (Merger & Acquisitions advisors) support you throughout the entire sales process. With their objective and professional methods, they help you develop a valid valuation. The value of your organization is determined using methods such as the DCF method, the multiples approach, or the EBIT method.

Feel free to contact us and see for yourself the expertise of CARL.

When Should the Company Value Be Determined?

In many small and medium-sized enterprises (SMEs), dedicated owners often prefer to pass the company on to their children. If succession can be arranged this way, a company valuation is usually not necessary.

If a family succession is not possible, determining an appropriate sale price becomes even more important. Potential buyers include:

• Previous executives
• External managers
• Other investors, such as those from the private equity sector

You can use the determined value as a basis for negotiations with these potential buyers.

Why is a Professional Company Valuation Essential?

To ensure that the endeavors of "company valuation" and "company sale" do not become a wild gamble with two or more participants at the negotiation table, you should rely on methods that provide valid results. Competent M&A advisors can assist you with this.

However, it is important to note that numbers alone are not everything, as will be illustrated below. An essential aspect of the company valuation process is emotionally preparing to part with the business, often considered a life's work, with appropriate lead time. A good M&A advisor can also prepare you for these factors.

The Value of a Company is Not Equal to the Sale Price

As a business owner and seller, you should be aware that the price you receive for your company upon sale is not the same as the value determined through a company valuation.

The company's value is an amount calculated using one of the five methods. The price, however, is only set shortly before the sale is finalized and is the result of the negotiation process.

What Other Factors Influence a Company's Sale Price?

The company's value provides a stable foundation for price negotiations. The price itself is influenced by various factors, such as:

• Supply and Demand: Is there currently a demand for the product/service your company specializes in?
• Market Trends: What do market trend forecasts predict?
• Synergies: Does the buyer benefit from additional synergies by acquiring the company?
• Resources: What resources are available to potential buyers?
• Presentation & Advantage Communication: How well can you or your M&A advisor present your company's strengths and weaknesses during negotiations and convince buyers?

These and other circumstances determine the final price paid for a company. Interested in more details? Feel free to reach out to us! Our M&A advisors are always available to answer your questions.

Adapting the Company Valuation Method Strategically

So, what is the best valuation method? There isn't a one-size-fits-all answer. Methods can and should be strategically adjusted to steer price negotiations in a new direction.

Ideally, both sellers and buyers should come out as winners and celebrate the success together.

Company Valuation Methods – The Basic Procedures

In M&A circles, three fundamental methods for company valuation are common:

1. Earnings Value Method
2. Asset-Based Method
3. Market Value Method

These are valuation methods with indicative characteristics. This means that instead of providing detailed data, these methods offer relatively rough guidelines.

Additional Methods for Determining Company Value

Of course, there are additional alternatives that provide deeper and more detailed insights, such as the following:

1. Company Valuation Based on the Median Method
2. Company Valuation Using the DCF Method (Discounted Cash Flow Method)

If the original owner continues to provide their expertise to the buyer during a transition period – for example, through a minority stake – this can increase the company's value.

This factor can bring many benefits to buyers, making them willing to accept a higher company value and pay a correspondingly higher price.

1. The Earnings Value Method: A Classic Approach to Company Valuation

As a seller and former business owner, you base your arguments in the earnings value method on the past. This means you demonstrate your company's value using historical data (e.g., from the last three years).

Meanwhile, buyers must look to the future when acquiring a business. They are interested in future successes and profits they can achieve with the acquired company.

In this context, a "time alignment" is necessary to satisfy both parties and enable a transaction. This alignment should occur as early as possible in the negotiations to avoid misunderstandings and dissatisfaction, ensuring successful company sales.

What Does the Earnings Value Method Entail?

In the German equity market, the earnings value method is one of the classic methods for determining a company's value. It applies the expectation principle, meaning the future earnings of the organization and the associated risks are calculated.

Earnings are paid to the owners either as a lump sum or as a continuous income stream. Risk factors are determined by calculating the capitalization or discount rate.

The earnings value method calculates the discounted expected dividends, the discounted or free cash flow of the company. The business results of the last three to five years play a major role. From these figures, an average company value is calculated.

Ultimately, it is an adjusted operating result before deducting taxes and interest. In English, this is known as Earnings before Interest and Taxes (EBIT).

Want to learn more about EBIT? Check out our glossary or our related article on EBIT.

Earnings Value Method: What Else is Considered?

Of course, other metrics are also included in this valuation method. All the values help to make forecasts for the future.

From a buyer's perspective, the return on the invested capital, i.e., the purchase price, must reach a certain level to be profitable. The assessment period usually covers three years.

Conversely, the previous owner values a reasonable financial cushion to enjoy leisure time or pursue a new venture.

2. The Asset-Based Method: Weighing Everything for Company Valuation

In the asset-based method of company valuation, you can almost picture two negotiating partners sitting at a table with a traditional balance scale in the middle.

The business owner emphasizes their intention to sell by placing all tangible assets on their side of the scale. These assets might include:

• Vehicle fleet
• Machinery
• Real estate
• Buildings
• Inventory
• Finished goods necessary for operations

Before the negotiating partner on the other side, simply put, places counter-values in the form of capital on the scale, provisions and liabilities are deducted.

Ideally, a balance is achieved, but this is rare. The balance scale is likely to tip in one direction or the other.

What Makes the Asset-Based Method Problematic?

The issue with this method is that it only determines a current purchase price without considering potential future developments.

Whether through anticipated restructuring, innovations, or social events promising a surge in revenue and thus an expected increase in value.

3. The Median Method: Combining Substance and Earnings

To create good reference points for both parties in succession planning or company sales,

you should include the median method in your valuation approach.

Determining Company Value Using the Median Method

The weighting between the forecasted future earnings and the calculated substance depends significantly on the type of each company.

While, for example, a real estate company has a lot of substance, a consulting firm focuses more on earnings. Here, the weighting could be 30% (substance) and 70% (earnings), for example.

Once both values are determined in the company valuation, they are processed mathematically, as shown in the following formula, based on the example mentioned:

Company Value = (Substance x 0.3) + (Earnings x 0.7)

In practice, the relevance of this company valuation method is viewed differently, which can lead to differences between the negotiating partners.

4. The Market Value Method: Competing with Multiples in Company Valuation

It's an open secret that business owners often compare themselves with competitors in the market. Whether for "sporting reasons" or to give their own company a boost, this approach is also used in the market value method (also called the multiples method) for company valuation.

How is Company Value Determined Using the Market Value Method?

The basis is the earnings value with the EBIT figures determined from the last two years, the current year, and the expected results in the next two financial years.

At this point, the multiples come into play. These are data from comparable companies in the industry, such as publicly available profit and loss accounts or the sale price achieved.

This creates a benchmark for the company to be sold – which flows into the formula as a multiplier to calculate the company value. This value can rise or fall, depending on the company's market standing. Industry-specific multiples tables, which are freely available, provide good guidance.

To obtain a relevant result, finding comparable companies as multiples is crucial. For example, it would make little sense to compare a brewery with a bottle manufacturer, even though there may be some overlaps.

5. The Discounted Cash Flow Method (DCF Method): Company Value with a Focus on the Future

DCF stands for Discounted Cash Flow and is a valuation method currently trending. According to the standards of the Institute of Public Auditors in Germany (IDW), the DCF method, alongside the earnings value method, is internationally recognized.

The DCF valuation methods are highly future-oriented. Therefore, entrepreneurs seeking a buyer or successor can assume that the primary focus is on continuing the business.

How Does the DCF Method Work?

One way to determine the purchase price within the DCF method is the Free Cash Flow approach (FCF).

Free Cash Flow refers to the funds available after a business year, after deducting all operating costs, taxes, investments, and repayment of existing loans.

This value is used to forecast future development. This is relatively accurate for up to three years but becomes less accurate the further the forecast extends.

After three years, it becomes more challenging for the buyer to calculate the important capitalization rate for their investment. This is mainly due to market uncertainties and potential social and political developments that are not foreseeable.

Subjective Criteria in Company Valuation: Beyond the Numbers

When considering the entrepreneur's personality in the company valuation process, the picture changes: If their influence is high, it may negatively impact the sale price if they leave the company directly.

On the other hand, if their influence is minimal, as key responsibilities are handled by management, it may positively impact the sale price.

Other factors in this context include:

• The product portfolio or services
• The know-how of the employees
• The customer structure
• The reputation within the industry compared to competitors

A company's value is composed of many factors. Our experienced M&A advisors understand this complexity and aim to secure the best price for your company.

Conclusion: Is There an Ideal Method for Company Valuation?

When we compare the methods in a company valuation overview, it's clear: there is no perfect method. None of the methods described above fits like a tailored suit to every small or medium-sized company.

The five common methods of company valuation once again in overview:

1. Earnings Value Method (EBIT = Earnings before Interest and Taxes)
2. Asset-Based Method
3. Median Method
4. Market Value Method
5. Discounted Cash Flow Method (DCF Method)

A much more efficient approach to professional company valuation is to use a good mix of various valuation methods. A good M&A advisor can tell you which of the five company valuation methods will create a good mix for your company.

Additionally, the calculated company values can differ significantly depending on the method. It usually takes several rounds of negotiations – much like a tennis match played over several sets – until the purchase agreement is signed.