Business valuation methods, the most common mistakes and how to avoid them
An essential factor in the M&A process is the determination of the value of the company being divested.
- The seller ‘s goal is usually to compensate future lost company profits by (with oder through?) the purchase price.
- The buyer is interested to achieve a minimum return compared to other investments.
These different interests of seller and buyer often lead to corresponding conflicts in the price negotiations.
As different as the reasons for a company sale may be, so are the possible methods of business valuation.
Methods of business valuation
Since the net asset value method (= individual valuation method) is used only in rare cases, I focus on methods based on capitalised earnings and on the comparative value methods, as outlined below:
The most commonly used valuation methods in M&A practice are methods focusing on the capitalised earnings where future earnings prospects are assessed. That means, only cash flows directed to the buyer after the effected transaction are considered. In order to achieve the most accurate forecasts of the returns, extensive gathering of information and their evaluation is necessary.
A) Methods based on capitalised earnings
Capitalised earnings method (income value method)
This kind of valuation determines the gross capital value of the company. Specifically, future cash inflows and outflows are determined, and they are discounted at present cash value to predict the future profitability of the company. It is important to be realistic about future interest rates and to forecast future cash flows as accurately as possible, which is one of the biggest challenges in this process.
The prerequisite for a reliable forecast is therefore a clean analysis of historic data. This is usually divided into the following areas:
Since it is a forecast for the future and since reactions within the company are different depending on different market changes, usually several scenarios are calculated. These are then assessed and weighed with a risk factor. The result of it is a weighted average.
Discounted cash flow (DCF) method
A very common and often recommended method for international transactions is the discounted cash flow (DCF) method. The DCF method calculates the enterprise value by forecasting and discounting future free cash flows. The calculation of the free cash flow differs from a normal cash flow statement by using EBIT or NOPAT (= EBIT x (1 tax rate)) as a basis and excluding cash flows from financing activities.
This serves to use only the operational activity of the company as the basis of the valuation and, to decouple the cash flows from the capital structure. The capital structure is included in the valuation via the WACC, which is used to discount the cash flow. In practice, the forecast period for future financial surpluses is divided into two phases (phase method). For the first phase, the cash flow forecast is based on a detailed planning calculation. The corresponding forecast period usually comprises three to five years. For the second phase, the valuation process is assuming constant or evenly increasing free cash flows to calculate a final value.
The DCF method plays an important role not only in the case of a corporate sale, but generally for the overall decision-making processes of the management.
B) Comparative value methods
Comparative value methods determine company values or company prices empirically. Possible problems of the previously mentioned methods, i.e. uncertain forecasts and inaccurate determination of future surpluses and capitalization interest rates are ignored. In contrast, the valuation is based on the consideration that comparable objects should also have comparable prices.
Valuation of comparable transactions
In this method, the valuation is not a result of a calculation, but based on the values of comparable M&A transactions of companies with similar business models or similar products and services. Usually, EBIT or EBITDA and revenue are compared in relation to the implied enterprise value (EV) from the transactions used. The result is a multiplier (for example, 5x EBIT or 0.6x revenue). In the next step, you apply these multipliers to your own company and calculate the corresponding company value.
Valuation of comparable listed companies
This method is based on the analogy principle. The valuation basis is the published data of listed companies of the same type and value. In the case of small to medium-sized companies, due to lack of data, listed companies are used for this as well, applying a deduction on the company value.
The most commonly used ratios are Price-to-Earnings (P/E), EV/EBITDA, EV/EBIT, EV/Sales and
Common mistakes in business valuation
In addition to unrealistic assumptions and forecasts, the following mistakes are the most common reasons for poor valuation results:
An independent M&A advisor can help with his knowledge and experience to avoid some of these mistakes and assist in conducting a fair valuation of the company.
Different valuation approaches and methods lead to different results. For those involved in the sale of a company, it is important to understand how the different values come about and how they must be interpreted in order to determine the most realistic value for the company – with the aim of finding the optimal sales price.