Company valuation: How to calculate the company value

Company valuation for the purchase/sale of companies or parts of companies

The topic of “company valuation” often stirs the emotions. In particular, shareholders of family-run companies often see a higher value in their companies than it arithmetically results and than it can be achieved on the market. This is because companies are often associated with a long family history and their own lives. Family entrepreneurs see their personal success reflected in the value of the company.

Example: For a prospective buyer who can tap interesting synergy potentials in combination with his existing business through a purchase, the value of a company to be sold may be higher than for another prospective buyer who would run the company as a stand-alone unit. The purchase price would be the same for both prospective buyers, although the first will have a higher willingness to pay.

Therefore, it is important for entrepreneurs and managers who want to sell a business or company to understand what qualities make up the value from the buyer’s perspective.

Methods for business valuation

As long as you do not know any concrete prospective buyers whose strategic or operational interests you can include in the valuation, your only option is to determine an objectified value, which can then be used for the interpretation of a realistic purchase price corridor.

Depending on the intended use, this objectified value is determined differently. The focus is always on the benefit that accrues to the shareholders from the company after taxes. Valuation guidelines can be found in the IDW S1 standard.

An operating company for which it is assumed that business operations will continue (“going concern”) is valued on the basis of the financial surpluses which the company generates and which can be distributed to the shareholders. Two methods have become established for this purpose: the Ertragswertverfahren, and the Discounted-Cashflow-Verfahren. The approximate Multiplier method is widely used in practice, but lacks methodological underpinnings.

A closed company is valued using the liquidation value method based on the sum of the values of all assets. The assets are determined using the net asset value method. Also Trademark and property rights can be valued.

The price of a company, a business operation or a business is developed in the course of negotiations. The price is the exchange value that you can obtain for your business at a certain point in time under certain conditions. This price may well differ from the objectively calculated value. Prospective buyers may be able to tap synergy potentials through the acquisition, which justify a higher willingness to pay.

Calculate company value: Simple with a rule of thumb

In practice, rules of thumb are often used, for example “last sales x factor” or “previous EBIT result x factor”. As a rule, these rules of thumb do not do justice to the need for an appropriate assessment of the actual value of the company. Such valuations use past successes as a basis for valuation; they are not forward-looking. What is relevant, however, is the value that will accrue to the new owner from the purchased company in the future. Furthermore, the first approach only takes sales into account, not operating profit. Such approaches are common in the retail sector, but are not methodologically sound.

IDW S1 as a valuation guideline

The Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer in Deutschland e. V., IDW), based in Düsseldorf, Germany, supports the work of auditors, among other things, through standards. Standard 1 (S1), which was published by IDW in 2008, relates to business valuations. It contains the following seven principles for conducting business valuations:

  • decisiveness of the purpose of the valuation
  • valuation of the economic entity (clear, meaningful delimitation of the entity to be valued
  • reporting date principle
  • valuation of assets required for operations (cannot be recognized as a separate value in accordance with the inflow principle)
  • valuation of non-operating assets (to be added to the enterprise value as net liquidation value)
  • irrelevance of the accounting principle of prudence
  • comprehensibility and comprehensibility of the valuation approaches

Examples of company valuation

There are various approaches to business valuation. Listed companies are the easiest to value:

Example: for listed companies, the price is exactly equal to the number of all shares multiplied by the share price. This is the market capitalization. At any given moment, it represents how much market participants are willing to pay for shares of the company, the stock.

This is not so simple for a company that is not listed on the stock exchange. However, comparisons with listed companies can help to make the calculated value of a company more plausible.

Example: An unlisted, medium-sized company reliably generates an EBIT of 15% of its sales of 30 MEUR, i.e. 4.5 MEUR. A listed company in the same industry generates an EBIT of 7.5% of its sales of 5 billion EUR, i.e. 375 MEUR. From the listed company we know that the market capitalization is 2 billion EUR. The ratio of the market capitalization to the EBIT result is 5.333. The value of the listed company is therefore 5.333 times the EBIT result.

Transferring this to the unlisted company, we can assume that the enterprise value is 5.333 times the EBIT result of 4.5 MEUR, i.e. 24 MEUR. Because this is a smaller company and because the fungibility is not the same as for a listed company, appropriate deductions are justified; but at least we obtain an order of magnitude for a reasonable enterprise value with a simple comparison procedure.

Such comparison procedures can also be used if it is known for what price comparable companies have traded. However, obtaining such often confidential information is difficult. If no relevant information about transactions that have taken place is available, you will have to rely on computational methods that use either earnings as a base figure or cash flow.

Conclusion on business valuation

Every company valuation should be carried out in a forward-looking manner. The only significant factor is the value that will flow to shareholders from the company in the future. There are recognized valuation methods available for this forecast, each of which is particularly suitable for specific purposes. The company valuation should be based on the principles of IDW S1.

An important insight is that the value of a company can be perceived quite differently depending on the contribution of the company to given constellations: The value is what one receives; the price is what one pays.

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