Any business is evolving all the time and company valuations may be difficult. Valuation methods generally look at estimated future profits or discounted cash flow to arrive at a current value for the business.
The minimum valuation of a business is the break-up value. This is the value of the assets less liabilities of the business. This asset valuation is normally lower than the real value of the business because it may not take into account intangible assets including goodwill which drive value creation. The business may have built up a local or national reputation - a trademark which people associate with its products - a loyal customer base or a skilled workforce with thorough knowledge of the business. The valuation of the company may be improved if it is possible to arrive at a goodwill valuation and a value for other intangible assets.
Multiple of net earnings
One of the methods of valuation for an established business is to use a multiple of the annual earnings or net profit. The profit made by a company is an indication of its value going forward as this enables the company to generate cash for further capital investment and payment of dividends into the future. Companies that are not listed on a stock exchange could take the typical price/earnings ratio for listed companies in the same industry. The price earnings ratio shows how many times one year's earnings investors are prepared to pay for companies in the industry. A company valuation for an unquoted company in the same industry could be arrived at by multiplying the company’s net earnings by the typical price earnings ratio for the industry.
Discounted cash flows
Another method of measuring a company’s value is a projection of cash generated by the business into the future. The value of the company could be equated to the future cash flows provided that these are discounted for the time value of money. Future net inward cash flows must, therefore, be discounted at the rate which the company must pay to the providers of its capital (known as the weighted average cost of capital). The estimate of future cash flows is uncertain and any business is subject to risks that cannot be measured into the future. The valuation may, therefore, need to be adjusted for a risk factor (known as beta) to measure the sensitivity of the cash flows of the company through business cycles.
Where a company’s shares are quoted on a stock exchange, the market capitalisation may be used to value the company. The market capitalisation reflects the views of investors as to the value of the company based on the information available in the market.