How a company is valued: three methods on one example
The value of a company is not one number but a range, and it depends on the method, the assumptions and the purpose of the valuation. Three methods applied to the same example show why.
The question “what is my company worth” usually comes up when the answer is already urgent: a buyer has appeared, a partner wants out, the bank asks for a basis or an inheritance is being divided. That is when it turns out there is no simple answer, and that is not a weakness of the profession but the nature of the matter.
Value is not the same as price
Value is the result of a valuation: what the company is worth based on what it has and what can be expected of it.
Price is the result of negotiation. It is also affected by things that are not in the valuation: how much of a hurry the seller is in, how many buyers are interested and what the buyer can do with the company that the current owner cannot.
A valuation therefore does not give the number that will be written in the contract, but a range within which it is reasonable to negotiate, and the arguments for it.
The example
Take a manufacturing company with these figures. They are invented, but the proportions are realistic.
| EUR | |
|---|---|
| Annual revenue | 4,000,000 |
| EBITDA | 600,000 |
| Book value of equity | 1,200,000 |
| Loans | 900,000 |
| Cash | 200,000 |
| Net debt | 700,000 |
1. The asset-based method
It starts from the balance sheet: assets less liabilities, with book values adjusted to market values.
In the example, the book value of equity is EUR 1,200,000. The hall was bought fifteen years ago and is now worth EUR 400,000 more than the books say. On the other hand, EUR 100,000 of stock is obsolete and cannot be sold.
Equity value: 1,200,000 + 400,000 − 100,000 = EUR 1,500,000.
The method suits companies whose value lies in assets (property, holding companies) and companies that are not profitable. Its weakness is that it does not see what is not on the balance sheet: customers, people, know-how and earning power.
2. The market method (multiples)
It starts from the ratios at which comparable companies have been sold. The most common is enterprise value to EBITDA.
If comparable companies in the industry sell for four to six times annual EBITDA, a multiple of five gives:
| EUR | |
|---|---|
| EBITDA × 5 | 3,000,000 |
| Net debt | −700,000 |
| Equity value | 2,300,000 |
With a range of four to six, equity value runs from EUR 1,700,000 to EUR 2,900,000.
The method is quick and easy to understand. It has two weaknesses. First, there are few truly comparable transactions for small and medium-sized companies in Croatia, and data on them is rarely public. Second, everything depends on which EBITDA is used, more on which below.
3. The discounted cash flow method
It starts from how much cash the company will generate in the future. Those future amounts are reduced to today’s value at a rate that reflects risk.
Assume the company currently generates EUR 350,000 of free cash flow a year, that this will grow by five per cent a year for five years and then by two per cent, and that the appropriate discount rate is 12%.
| EUR | |
|---|---|
| Present value of cash flows in the first five years | 1,450,000 |
| Present value of the period after that | 2,580,000 |
| Enterprise value | 4,030,000 |
| Net debt | −700,000 |
| Equity value | 3,330,000 |
The method is theoretically the most accurate, because it values exactly what the buyer is buying: future earnings. It is also the most sensitive to assumptions. With a discount rate of 14% instead of 12%, equity value in the same example falls to about EUR 2,650,000. It is also worth noting that almost two thirds of the value comes from the period after year five, the part that is hardest to predict.
Why three methods give three numbers
| Method | Equity value |
|---|---|
| Asset-based | 1,500,000 |
| Market | 1,700,000 – 2,900,000 |
| Discounted cash flow | 2,650,000 – 3,330,000 |
The range is not an error. Each method answers a different question: what the company has, what the market pays and what the company will earn. The valuer’s job is to explain why the numbers differ, which method deserves more weight in the specific case and where within the range the realistic value lies.
What changes the result most
Normalising earnings. Reported EBITDA is rarely the one the buyer will achieve. The owner pays themselves a salary below or above market, private costs run through the company, last year had a one-off job or write-off. Each of these items is adjusted, and every adjustment of EUR 50,000 at a multiple of five means EUR 250,000 of value.
Dependence on the owner. If key customers are tied to the owner personally, the buyer is not buying a company but the hope that the customers will stay.
Concentration. One customer with 40% of revenue or one supplier with no alternative increases risk and reduces value.
Working capital. A company that needs more and more cash in stock and receivables to grow is worth less than one that grows without it.
Hidden liabilities. Disputes, guarantees, tax risks, unpaid overtime. They do not show on the balance sheet, yet they reduce the price. Due diligence deals with them.
Reliability of data. A buyer who does not trust the numbers asks for a discount. Tidy records and a system in which data can be verified directly affect the price.
When a valuation is done
- buying or selling a company or a stake
- a partner joining or leaving
- mergers, demergers and other corporate changes
- inheritance and transfer to the next generation
- negotiations with a bank or investor
- disputes between owners
The best moment for a valuation is a year or two before a sale, because it shows what reduces value while that can still be fixed.
The figures and multiples in this article are for illustration and cannot be applied to a specific company. If you are facing a decision that depends on value, describe the situation to us. Read more about what we do in the description of our due diligence and valuation service.