Methods and approach to valuing companies in practice

Valuing a company is a challenging task. The following summary gives you an insight into the topic of valuation methods and approaches to valuing a company.

Valuation methods in a nutshell

There are a variety of methods to value a company. They can basically be subdivided into two categories: methods focusing on asset and such focusing on earning power. In addition to this, market value methods can be applied in order to verify the plausibility of the results obtained by the other methods. In essence, effectively paid prices of past transactions are being used as benchmarks (transaction multiples).

When it comes to putting a financial value on SMEs “transaction multiples” are particularly valuable as they make it possible to integrate recent experiences for a very intransparent market, into the valuation process. In practice it is common to use a mix of relevant methods for the valuation. The valuation mix applied can vary depending on the situation of the company within its life-cycle and the type of business model.

Thanks to its experience of more than 740 completed company sales, Business Broker AG has a data base on prices effectively paid during the sale of SMEs. This data base in combination with the practical experience of our consultants enables us to produce company valuations that reflect the reality of the market.

Net asset value method

The net asset value method takes into account all the assets listed on the balance sheet. The net asset value is generally calculated based on the "going concern" principle (so-called reproduction values). Together, all the assets of a company form the total property of the company and are referred as the gross assets. In order to obtain the net asset value of the company, i.e. the equity value, the financial obligations (all the company's debts and payables) have to be deducted from the gross asset value. Here it is important to note that the assets in the financial accounting statement (tax balance sheet) represent book values and not reproduction values. The difference between the book values and the reproduction values comprises hidden reserves by which the book values must be adjusted. The hidden reserves imply latent taxation, because if the hidden reserves were to be dissolved in the future, it would have a positive influence on the income statement and a higher profit would be recorded. These latent taxes must be taken into account in the calculation of the net asset value.

The net asset value is a snapshot of the existing assets, i.e. the existing substance of the company. The net asset value represents the effective value of the equity capital and can be viewed as a the low boundary of the valuation, since the assets are materially available at the point when the valuation takes place. If a sale price ends up being less than the net asset value then the liquidation of the company may be financially more advantageous for the owner. This method is not suitable as the sole means of valuing a company, since the company's future earnings are not taken into consideration at all. You can find further details on the net asset value method in the full version of these explanations.

Capitalised earnings method

The capitalised earnings method values a company by means of the expected earnings that the company will generate for the owner in the future through the deployment of its existing assets. Possible future earning streams may be profits or cash flows. The various capitalised earnings methods vary depending on the type of the earning. Earning streams that the company owners are expected to accrue in future are adjusted at the point of the valuation. The underlying argument in favour of this is the present value of money. Further details on the present value of money can be found in the full version of these explanations.

In order to generate earnings, the company uses not only its material assets, but also its immaterial assets such as its customer base, market position, reputation, employees and patents. With these earings based methods the net asset values and the immaterial asset values are not explicitly taken into account, however they actually form a prerequisite in order to be able to generate profit.

The simple capitalised earnings method

You don't need detailed planning of future years to carry out a simplified capitalised value calculation. In this case it is assumed that an adjusted sustainable profit (before interest) will be achieved. It is also assumed that no changes will take place in the net working capital and that the investments will equal to the depreciation, so only replacement investment will be carried out. This long-term profit is discounted with the company-specific capitalisation rate, giving the gross company value. In order to get to the net company value, the debt of the company must be deducted from this. The capitalisation rate mentioned reflects the predictability of the long-term profit in the future, personal dependencies, cluster risks in the customer base, supplier dependencies, sector and financial risks. Further details on determining the capitalisation rate are provided in the full version of these explanations.

The financial value of the company reacts sensitively to this capitalisation rate. The higher this ends up (more risk), the lower the resulting value of the company, hence sensitivity scenarios are often applied, which make the influence of the capitalisation rate on the company valuation transparent.

Discounted cash flow method

With the discounted cash flow method (DCF method), the company value is determined based on future cash flows. Here the future free cash flows need to be deduced or forecast and then discounted with the tax rate-adjusted weighted average cost of capital (WACCs) at the point of the valuation. The free cash flow refers to the stream of money resulting from the entrepreneurial activity, which is freely available to debt- and shareholders after investments. This capital can be used to pay off creditors or to pay out dividends to shareholders. The DCF method according to the entity approach is considered best practice.

Starting from the point in time of the valuation, an expected profit and loss statement is generated for the next 4-5 years. For the time period after this, a simplified scenario is applied. A so-called residual value is determined. This value is comparable with the adjusted long-term profit in accordance with the simple capitalised value method. The problem when defining the planning horizon lies in the relative weight of the residual value. The further into the future the planning horizon extends, the more difficult it will be to project the future free cash flows. At the same time, the relative influence of the residual value on the company valuation is reduced. In normal cases it makes sense to forecast approx. 4-5 years, as this can be backed up and is comprehensible. As trade-off, a higher proportion of the residual value against the value of the company must be accepted. Further details on calculating the discounted cash flow can be found in the full version of these explanations.

Mean value methods

The mean value method is a combination of the net asset and capitalised earnings methods. It involves a weighted averaging. The Swiss method or called practitioner method is particularly popular here, because the tax authorities often apply this method to determine the market value of non-listed companies.

Company value (net)	=	x × capitalized value (net) + y × asset value (net)
		(x + y)

Swiss method:

Company value (net)	=	2 × capitalized value (net) + asset value (net)
		3

Here the tax authorities apply a capitalisation rate that can strongly distort the result for the capitalised value.

Brief digression on the topic of goodwill

The difference between the capitalised value and the net asset value is referred to as goodwill. The goodwill describes the component of the purchase price that is paid in addition to the value of the physically available liquifiable assets, i.e. for the customer base, the reputation, the brand, the market position, the access to employee performance or other immaterial assets. The level of the goodwill sometimes depends on the industry. If a company with a capital-intensive business activity is sold, then the goodwill tends to be lower in relation to the sales price than in the case of a company that is a pure service provider, where less physical substance is available.

Market value methods

For stock exchange listed companies, the company value can be determined by the prices paid on the stock exchange (trading multiples) or with the takeover prices published in the press (transaction multiples). Trading multiples and transaction multiples are summarised under the term market multiples (multipliers). Important market multiples are the turnover, EBITDA, EBIT and net-profit multiples, the price/earnings ratio (P/E ratio) or the market-to-book ratio. With non stock exchange listed companies, a comparison with prices paid on the stock exchange is a non suitable approach given the size, stability, earnings and financial weight of stock exchange listed companies.

Common multiples are:

Company value (gross) according to turnover multiple
= Turnover × turnover multiple

Company value (gross) according to EBITDA multiple
= EBITDA × EBITDA multiple

Company value (gross) according to EBIT multiple
= EBIT × EBIT multiple

Company value (net = equity capital) according to pure-profit multiple
= Pure profit × net-profit multiple

It's important to use the same basis when applying the market multiples. Values are based either on an entity level (overall company level) or on an equity level. It's also advisable to form an average value of the individual multiples in order to balance out any possible distortions. With non stock exchange listed companies, particularly with SMEs, a comparison with prices paid on the stock exchange is practically unusable given the size, stability, earnings and financial weight of these companies.

Owners profit

Of particular importance is the owners profit. This represents the income that is available to the owner of any given company in order to make investments for the future or to pay out to oneself as a salary, bonus or dividend. The starting point for the calculation of the owners profit on the EBITDA level is always the EBITDA according to the annual financial statement. EBITDA stands for earnings before interest, taxes, depreciation (on tangible fixed assets) and amortisation (on immaterial assets). In the context small and medium-sized companies in particular, this represents a key indicator in order to establish the value of a company. This value is not influenced by the financing structure and the status of the investment cycle and is therefore one of the most meaningful parameters. A company that has just made investments is confronted with higher depreciation and amortisation and lower profit than a company that has made no investments for a longer period of time. In order to get to the owners profit (on the EBITDA level), the gross salary (including social security contributions) of the owner and any other correctional elements must be added back in. Multiplied by a factor based on market experience values, it results in a fundamental price indicator. When valuing small and medium-sized companies in particular, where the owner still has an active role and takes the liberty to have his/her company pay for some of his private expenses, the owners profit and corresponding multiples represent an important valuation method.

With 740 company sales over the last ten years, Business Broker AG has been able to develop a valuable database in relation to these multiples and is therefore able to produce an accurate value indication for a company in an extremely intransparent market.

Mix of methods

The selection and relative weighing of valuation methods is the subject of constant discussion. First it's worth mentioning that one single method of valuing a company is of limited value by itself. Based on our experience, we prefer the use of a mix of valuation methods. The net asset value can be seen as a minimum value when it comes to establishing a price range. Following that, the capitalised earnings value can be determined by using the discounted cash flow method. The two results are then weighted and combined with the net asset method combined according to the mean value method (often in form of the practitioner method) and finally compared against the capitalised earnings value via multiples, which is already a time and method-related average We therefore combine the discounted cash flow method with our wealth of knowledge from transactions already carried out (transaction multiples).

Summary

Valuing a company is not a matter of finding the absolute right value. Company values do not represent objective values, but rather are based on many assumptions and points of view that are established subjectively. It's really about determining a price range that can be verified and communicated. When it comes to interpreting the results and the plausibility check, however, the consultant's experience is crucial. Thanks to his/her knowledge from past valuations of companies in a variety of industries and involving huge diversity in terms of company-specific peculiarities, the experienced consultant has over time has developed a practice- and target-oriented perspective and is very well able to judge whether the company value deduced and the mix of methods applied make sense or not. In combination with the broad basis of data on prices effectively paid for SMEs in Switzerland, Business Broker AG is able to ensure that our valuations are not merely theoretical but are aligned with the reality of the market.

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