Methods and procedures for company valuation in practice

The valuation of a company is an extremely challenging task. The following article gives you an overview of the most common reasons to commission a business valuation, the recognised methods and procedures to be chosen.

As you will notice, any scientific evaluation method provides different values – a review says very little without a professional interpretation of the individual results and the knowledge of realised projects.

The text is divided as follows:

• 1. General information on a company valuation
• 2. Reasons and occasions for a company valuation
  • 2.1 Company Sale / Succession Plan
  • 2.2 Strategy definition
  • 2.3 Arbitration value
  • 2.4 Inheritance
• 3. Company Valuation Methods
  • 3.1 Entity vs. Equity Approach
  • 3.2 Substance-value method
  • 3.3 Earning power methods
  • 3.4 Market Value Method (multipliers, multiples)
  • 3.5 Ownership profit (-EBITDA)
• 4. Procedure during a company valuation
  • 4.1 Revision of financial statements
  • 4.2 Company valuation method-mix
  • 4.3 Comparison and interpretation of results
• 5. Conclusion

1. General information on company valuation

One must basically differentiate between the theoretical value of the company and the realisable value of the company: The theoretical value of the company can be determined using various methods, each method generates different values. Therefore, there is no right or wrong theoretical value of the company, but different values, which are varyingly plausible for different viewers.

The realisable value of the company can only be established for a non-listed company if the company is actually sold. It is always a snapshot.

An assessment can be divided roughly into two types of methods: the net asset value and the income value. With the intrinsic value method, the company value is made up from the rated capacity, minus the rated debt. Here the assets can be used at book value, replacement or liquidation value. Hidden reserves must be considered accordingly.

The evaluated value of a company, it is not enough to use only the intrinsic value. The tangible assets alone do not create value, if a corresponding income is not earned. It can sometimes also be the case that with very little tangible assets one can generate a high revenue. Therefore, a company’s earning power also plays an important role in the evaluation.

The income capitalisation methods show what can be earned on the existing assets. The earning power does not include the value of intangible assets such as components of the customer base, market position and reputation. It is also determined by the company’s strategy, the market situation and the capabilities of the management.

2. Reasons and occasions for a company valuation

The reasons for carrying out a business valuation are varied. In the context of a corporate sale or succession planning, the business valuation is essential for determining the price. The company valuation is also a very valuable tool for corporate governance in strategy definition and selecting alternatives. Company valuations continue to be required in legal cases as part of an expert report as well as in the establishing and distributing inheritances.

2.1 Company Sale/Succession Plan

As the owner of your company decides on either a sale or succession planning, it is important to assess the site by way of a company valuation. When evaluating a company is clear what value the company has at the time of the valuation. The right arguments can be found during the price negotiation phase by means of the factors analysed. The company value is therefore the same as an argumentation value. Different scenarios (conservative, realistic, optimistic) are taken into account during the valuation. The argumentation value shows that the calculated value is generally not equal to the eventual price to be paid. There are additional specific and subjective aspects of negotiation.

2.2 Strategy definition

Based on a company valuation and the resulting lessons learned, improvement measures can be established in respect of a subsequent sale of the company. Since the value drivers of the shareholder value are crystalised in a valuation, it is possible to use this to (re)align strategy. It makes sense, for example, to check the value proposition of the individual cost components. The use of personnel, premises and the tied up capital (such as machinery or vehicles) should be scrutinised and checked rigorously for possible savings. On the revenue side it is critical if the generated revenue of a business unit also has a positive impact on the overall profitability of the company or if it pushes this down.

2.3 Arbitration value

When parties are in dispute, it may be necessary to determine the arbitration value of a company. As an example, the divorce process can be named here, where there will be a dispute over the amount of the developed assets in the form of the company value. Business Broker AG has experience in the preparation of court reports and takes on the corresponding orders.

2.4 Inheritance

Would you like to know what the value of your business is and what value you want to leave your descendants one day, then it is essential to determine a company's value, which is not only theoretically correct, but can also be achieved. We will help you determine a value that is not beyond the market and based on assumptions, one that has a meaningful relationship to reality.

If you have undergone the painful experience of having lost a family member who has built up a company over the years and you (possibly jointly with other heirs) are now faced with the issue of succession, it is imperative for the parties to use a comprehensible company valuation oriented to market prices as a decision basis.

3. Company valuation methods

There are a variety of company valuation methods, which as described above are divided into two basic categories: intrinsic value method and discounted earnings method. In addition, there are market value methods (multipliers, multiples), which are used for the valuation and which with other methods can make the obtained results plausible. It analyses what has already been paid in past transactions (Transaction Multiples) or what will be paid on the stock exchange for market prices (Trading Multiples). Furthermore, there are corporate policies that are theoretically correct, but not relevant in practice for SMEs, since they are simply not appropriate enough or are of too little importance or not documented enough (e.g. the valuation using the real options theory). In practice it is customary to use a valuation mix of the relevant methods. The valuation mix applied may vary industry to industry, however, it is based on the experience and the expertise of completed projects.

Business Broker AG has extensive practical know-how, which they can draw on in each individual project valuation.

3.1 Entity vs. Equity Approach

Two different perspectives and approaches can be pursued with all company valuation methods.

The entity approach takes into account the sources of income accruing to the equity investors and lenders. In other words, it is valued from the perspective of the overall company (Enterprise Value, Entity) and the gross value of the company is ascertained. If you subtract the debt, you get the net value of the company, which equals the equity. When selling a business it is the net value of the company that is relevant. This can also be derived directly from the equity approach. Only the equity holders who are entitled to sources income are capitalised. The direct derivation of the corporate value using the equity method is done, for example, in the stock assessment.

3.2 Intrinsic-value method

With the intrinsic value method, all existing assets are in the balance sheet, so the assets of the company are summarised. The intrinsic value is usually calculated on going concern values (so-called reproductive values). All assets together form the total of the company’s assets and referred to as the gross asset value. To work out the net asset value of the company, i.e. the intrinsic value of equity, the debt (all debt and liabilities of the company) is deducted from the gross asset value.


 

3.2.1 Book value, hidden reserves and deferred taxes

The assets in the financial accounting (balance control) represent book values and need to be revised first. The difference between the book values and the actual values includes undisclosed reserves to which the book values should be adjusted. The deferred taxes on hidden reserves can be drawn in since a positive influence is achieved on the income statement or a higher income is reported in a future release of hidden reserves. The deferred taxes can be taken into account when calculating the net asset values, in which the valuation difference (between book values and market values) is multiplied by half the tax rate and subtracted from the calculated net asset value. The use of half the tax rate takes into account, on the one hand, the subsequent collection of the taxes in time (time value of money) and, on the other hand, the scheduling of when to release the hidden reserves (the tax burden will not turn out quite so high).

3.2.2 Going concern value (reproduction or replacement cost)

With the intrinsic value for the going concern value, assets are considered to be the value that they cost at today’s replacement cost at market prices. The continuation value thus indicates how much the replacement cost would be to reproduce the company. The acquisition values at current prices are used, from which the depreciation (consumption value) is deducted on grounds of age, resulting in the replacement value.

3.2.3 Liquidation Value

The liquidation value is the value of the assets that can be attained after deduction of liabilities and liquidation costs. It should be noted that in a liquidation due to the tight time frame and because of the possible orientation of the assets to the purpose and the specialisation of the company, it may result in lower prices.

3.2.4 Non-operational assets

When valuing a company using the intrinsic value method, the operational assets are summed up in the first place. The company may have, however, additional non-operational assets such as real estate, which are not related to the operational activities, or there is excess liquidity that is not needed for the operation (this is not usually the case for smaller companies). These non-operational assets are to be listed separately or added in addition to the net intrinsic value and shown separately.

3.2.5 Conclusion for the intrinsic value method

The intrinsic value is an inventory of existing holdings (assets), i.e. the existing matter of a company. The net intrinsic value represents the effective value of the equity, i.e. the corrected tax values of assets of the hidden reserves, minus the debts or liabilities of the company. The intrinsic value can be seen as a lower limit in the valuation of a company because tangible assets at the valuation point are physically present.

3.3 Earning value methods

The earning value methods evaluate a company based on the anticipated sources of income, which the company will generate for the company owners in the future with the existing substance. The future sources of income may be in profits or cash flows. The individual earning value methods can be distinguished depending on the type of revenue. So the widespread Discounted Cash Flow method, valid as an assessment standard, is based on a cash flow factor and the pure earning value methods and also the excess profit methods to a profit factor. So-called dividend models (e.g. dividend discounting or the dividend growth model) are based on expected revenue in the form of dividends that accrue to the shareholders in the future. The dividend models are not listed here, because these are relevant for the stock assessment and also for listed companies with a constant dividend.

3.3.1 Basic principles of the Earning Value Calculation

3.3.1.1 Time value of the money and consideration of risks
Earning value methods are all based on the same methodology: Anticipate revenue that accrues to the company owners in the future will be adjusted to the time of evaluation. The basic argument for this is the time value of money. This means that a franc is worth more today than tomorrow, as the money today can be invested at a specified interest rate (risk free market interest rate). In addition to the time value of money, the risk is taken into account, with which the returns vary in the future, what is referred to as so-called volatility. The higher the volatility, the higher the risk and therefore the cost of capital with which the time delayed revenues are discounted, i.e. are transferred to the valuation date. The cost of capital is an interest rate that considers both the temporal component mentioned, as well as the revealed risk. Discounting specifically means that a future form of income (FS) is divided by the term (1 + interest rate)^{period (T)} to obtain the present value of the income (present value). The revenue can be profits or cash flows, which accrue at the end of each fiscal year to the company owner.


 

3.3.1.2 Determining the cost of capital
The amount of the capital costs has a major impact on a company's value, since the expected forms of revenue will be compared when evaluating the cost of capital and discounted at the WACC. The cost of capital consists of both the rates of return of equity (cost of equity) and debt capital (borrowing costs). To calculate the cost of capital, the cost of equity is weighted with the equity and debt capital costs by the percentage of debt. With the cost of debt, corporate taxes are also taken into account because the interest expenses are tax deductible. Hence the term tax-adjusted (WACC - Weighted Average Cost of Capital) is used (see Section 3.3.2 Discounted cash flow method). Equity is the most expensive capital. The required rate of return of the equity investors is much higher than the borrowing rate. By borrowing funds (for example in the form of a bank loan), the total capital costs are reduced, thereby changing the financing structure (it is the so-called financial leverage effect).

The required rate of equity can be determined using the CAPM (Capital Asset Pricing Model). Here a risk premium and, where appropriate, risk increases for the limited tradability (for listed companies) and the size (at small and medium-sized, unlisted companies) are added to a rate perceived as being without risk (e.g. 10-year Swiss government bond). The risk premium is derived from the product of the equity beta ß_EK and the market risk premium or market returns. The equity beta beta ß_EK indicates how much the stock price fluctuates compared to the market (e.g. in Switzerland SMI or SPI). The empirical determination of the equity beta ß_EK implies a stock market listing. Since each company has a different funding structure and capital structure, this must be taken into account when calculating the beta. This is done with the so-called Hamada's formula, which transforms the beta values ß_GK of the Stock Exchange (this refers only to the business risk) into the ß_EK, which in addition to financial risk even incorporate the company-specific financial risk. For unlisted companies, determining the cost of equity is more difficult because there are no empirical data on market beta derivation. In determining the betas, only the experience of past transactions, especially in the field of small and medium companies, plays a very important role. In addition, comparative values of publicly traded companies in the same industry can be used.


 

3.3.2 Discounted Cash Flow Method

The discounted cash flow method (DCF) is, as the name suggests, a cash flow-based company valuation method. First, the costs incurred in the future, so-called free cash flows are derived or predicted, and then using the tax-adjusted average cost of capital WACC_s discounted at the valuation date.

3.3.2.1 Calculation of Free Cash Flows (FCF)
Free cash flow estimates the cash flow from business operations, which, after investment in net operating working capital and fixed assets into the company's owners are, so to speak, freely available.

Free Cash Flow at Entity Level is derived as follows:

EBIT (Earnings before interest and tax)
- Adjusted taxes (based on EBIT)
= NOPLAT (operating profit before interest after adjusted taxes)
+ Depreciation on intangible assets
+ Amortisation of intangible assets
- Investments in working capital
- Capex (investments in fixed assets)
- Investments in goodwill
= Unlevered Free Cash Flow (FCF Company/Enterprise/Entity)

The DCF method according to the entity approach is considered as Best Practice, whereby the free cash flows are discounted to entity level with the tax-adjusted average cost of capital WACC_s. The tax adjustment with the WACC is necessary because in the calculation of free cash flow, taxes are directly deducted from EBIT (earnings before interest and taxes). This is theoretically incorrect because the borrowing costs are tax deductible and so taxes must not be subtracted directly from the EBIT, but from the EBT (earnings before taxes) - (disclosure of too high taxes). Since in practice it is difficult, however, to predict the exact applicable taxes, the "incorrectness" mentioned in the WACC_s is taken into account, so when determining the cost of debt, the taxes are incorporated and so the taxes that have been estimated too high are corrected again.

An income statement plan is drawn up for the next 4-5 years, starting from a valuation point. A simplified scenario is worked with for the time periods after the 4-5 years. A so-called residual value is determined. Here, the assumption is made that the investment currently meets the depreciation, so that the free cash flow to be discounted on a straight agrees on the entity level with the NOPLAT (Net Operating Profit Less Adjusted Taxes). The gross value of the company consists of the actuarial value of free cash flow at the Entity level together with the cash value of the residual value.

To obtain the net value of the company, the value of equity, the net debt (interest-bearing liabilities including loans from the owner - cash) is subtracted from the company's gross value.


 

3.3.2.2 Residual value, planning horizon, eternal growth
The difficulty in defining the planning horizon is the weighting of the residual value. The greater the number of planning years, the more difficult it is to plan the future free cash flows, because the quantity of the residual value is smaller than the value of the company. It therefore makes sense to forecast only about 4-5 years, as these are justifiable and understandable, and therefore accept a higher proportion of the residual value at the company's value.

In the planning of future profits or free cash flows one can make the assumption that profits should have an eternal growth after the planning horizon. In the denominator of the DCF formula, the growth rate g is then subtracted from the WACC_s. The assumption of perpetual growth NOPLAT is a very strong statement and must be viewed with great caution and above all provided with a reasonable and founded justification.


 

3.3.3 Pure earning value method

Aside from a detailed planning of the future years, one can perform a simplified earning value calculation. Here it is assumed that a perpetual profit (before interest payments) can be achieved and this profit corresponds as the equivalent to the free cash flow entity. This stems from the fact that there are no changes in working capital and that investments just meet the depreciation, which implies that only replacement investments will be made. The resulting profit is regarded as eternal and is hereby discounted with the non-tax adjusted WACC in this case, because the taxes in the calculation of EBIT (earnings before interest) are calculated correctly.


 

3.3.4 Goodwill

The difference between the revenue value and the intrinsic value is called goodwill. Goodwill describes part of the purchase price, which is paid in addition to the value of the material elements of capital, for the customer base, reputation, brand, market position, access to the work performance of employees and for other intangible assets. The amount of goodwill sometimes depends on the industry sector. If a company sells a capital intensive business, the goodwill in relation to the sales price is considerably lower than in a pure service company, where there are tangible assets.

3.3.5 Average value method (Mean value method)

The average method involves a weighted averaging of asset and revenue value.


 

3.3.6 Excess profit methods

The intrinsic value method and the discounted cash flow method can be connected with each other using the excess profit process. Here recoverable excess profit is added to the gross asset value over a certain period T. The excess profit is the difference between the budgeted profit before tax (earnings before interest) and the normal profit, which is the product of asset value and the non-tax-adjusted cost of capital (WACC). The budgeted profit can be higher than normal profit, for example due to a strong market position, due to competitive advantages, but it is time limited. The excess profit adopted for a certain period is capitalised with the present value annuity factor, composed as in the following formula:


 

3.4 Market Value Method (multipliers, multiples)

The corporate value can be determined with publicly listed companies by the prices paid on the stock exchange (trading multiples) or compared with the acquisitions, transaction prices (Transaction multiples) already paid for by the company. Trading multiples and transaction multiples are summarised under the term of market multiples (multipliers). Important Market multiples are revenue, EBITDA, EBIT, net profit multiple, the price-earnings ratio (PER or P/E ratio) or the Market-to-book ratio, where the multiples are always a multiple of the listed figures. With unlisted companies a comparison is made with prices paid on the stock market, however, proven to be relatively difficult. A comparison may be of use when establishing a price range.


 

In the multiple-evaluation it is important that it starts from the same base. Either one rates at the corporate level (enterprise value, gross, unlevered) or at the equity level (equity value, net, levered). It is also useful to form an average of the individual multiples, so as to balance a possible bias or offset. Moreover, it makes sense to form an average over several years for each included Multiple.

3.5 Ownership profit (EBITDA)

Particular attention is given to the important EBITDA Multiple. EBITDA stands for Earnings before interest, tax, depreciation (fixed assets) and amortisation (on intangible assets). This represents an important tool in corporate valuation especially for small and medium-sized companies. This multiplier is from the financing structure and influenced by the state of the investment cycle and therefore one of the most meaningful multipliers. A company that has just invested finds itself confronted with higher depreciation and a lower profit than a company that has made no investments over time.

The owner of earnings based on the EBITDA represents the actual cash flow generated, adjusted to reflect corrections and before depreciation. If one adds the gross salary (including benefits) to the EBITDA that the owner of the company has paid out to himself, this results in the owner earnings (EBITDA level). Multiplied by a certain factor, this represents a fundamental price indicator in particular regarding the evaluation of the profitability of small and medium-sized companies, which a DCF valuation may not make much sense. The origin of the term: owner’s profit (EBITDA), owner’s cash flows come from the Anglo-American term. Usually the owners themselves are active in the company and will benefit from various services provided by the company for him. In relation to an employee he would have to finance for such benefits for himself from his work income.

The starting point for calculating the owner’s profit at EBITDA level is always the EBITDA according to the financial statements. To which the following adjustments or corrections are to be made:

With over 100 sales of companies in the past four years, Business Broker AG has built up a very valuable database in terms of multiples, which are actually paid in the area of small and medium sized companies. Of course, this requires a prior revision of the financial statements as listed above.

4. Procedure during a company valuation

To perform a meaningful due diligence, regardless of the method chosen, some key steps are to be considered:

• Revision of the financial statements
• Business valuation with a method mix
• Comparison and interpretation of results

4.1 The revision of financial statements

The balance sheets and income statements for the past 3 years must be revised for non-operating, and extraordinary personal income and expenses or assets and liabilities. Examples of this can also include rented business premises, which are shown as an expense in the P&L account, but are not required for the business activities. Or the owner runs an expensive car and pays for its leasing costs through the business. These additional expenditures are to be neutralised or taken out.

4.2 Company valuation Method mix

The presentation and selection of assessment methods always gives rise to discussions. First, it should be noted that a company valuation method is limited to its own explanatory power. In our experience, the mix of company valuation methods has proven successful. The intrinsic value can be regarded as a lower limit in the definition of a bandwidth value. Thereafter, the earning value is determined using the discounted cash flow method and is weighted and combined together with the earning value discussed by multiples, which is already a temporal and methodological average, according to the average value method (this is often the mean value method). So we combine the discounted cash flow method with our extensive knowledge from existing transactions (Transaction multiples).

4.3 Comparison and interpretation of the results

4.3.1 Plausibility check

The plausibility of the valuation results can be done with technically simple valuation methods, like the pure income capitalisation method is. This makes sense particularly with the discounted cash flow method, in which the cost of capital, the planning figures and the residual value represent particularly value-sensitive factors, this makes sense. Furthermore, plausibility checks can be made with multiples. Crucial to the plausibility test, however, is the experience of the consultant from other projects. An experienced consultant can use his knowledge of the existing company valuations that come from different industries and are characterised by a variety of company-specific traits, for profit. He has developed over time a practical and goal-oriented perspective and is able to assess very carefully whether it makes sense to determine company value and apply a mix of methods or not.

With a company valuation, assumptions are made regarding the sales development and also the development of costs (staff costs, material costs, other operating expenses). In addition, with the earning value method, a certain cost of capital is set and used for discounting the flow of revenue. As the future is uncertain, it makes sense to work with different scenarios (conservative, realistic, optimistic), especially with regard to the sales of a company, which may depend in particular on the industry or market development, and with respect to different levels of capital cost percentages (company-specific risks). With the change in the cost of capital, it is easy to see how sensitively the earning value reacts.

4.3.2 Traceability

It is essential that the assumptions are critically analysed, especially with the earning value methods (specially the DCF method). One deals intensively with the company's business model and value factors, which responds sensitively to an assessment. It is not done with a purely technical valuation on the basis of a business plan or planning figures (plan P&L statements, projected balance sheets, schedule of cash flows). The assumptions must be readily comprehensible, so that an outsider sees and also understands the most important value driver on the valuation of a business.

5. Conclusion

The company valuation is not about finding the absolutely correct value. Company values do not represent pure objective values, instead they are based on many subjective assumptions. The point is to determine a value bandwidth, which can be used for plausibility and communication purposes. The bandwidth value of the earning value comes from the fact that different scenarios (conservative, realistic, optimistic) and various other assumptions are made. The income/cost development is evaluated and so are the business and financial risks of the company and the industry development of different variants. A lower limit is determined based on the intrinsic value that is physically present and which varies depending on the capital intensity of operations. Depending on the scenario, then the return value and the goodwill to be attained are specified as the difference between the earning and net asset value. All the results obtained in the context of a company valuation require expert assessment and a plausibility check. Only those who can see the value driving factors and an assessment of the underlying assumptions in detail, will be in a position to interpret the calculated value of the company.

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