Entrepreneurs often face a question what is the value of their business and there can be several reasons why one would like to know that. Predominantly such interest emerges when one wants to sell a company and/or account the market value of his/her business. In the light of previous a crucial question is how to calculate the value of a company?
Through the history of finance, several different business valuation concepts have been developed. Among the most widely used ones are asset-based, discounted cash flow (DCF-equation), comparison and option pricing models. All of them have their positive and negative sides, but also situations where they suit well and contrary cases, where there is no use of them. In practice, business valuation would sometimes demand a combination of methods, i.e. application of different formulas to different business segments.
The assets-based method is the simplest one, where the worth of the company is calculated based on its book value, liquidation value or market value of assets. The main problem of given model is that it directly does not take into account the ability of assets to create cash-flows in the future, although indirectly the price of an asset could incorporate its cash flow creation potential. For instance, if a company owns three pieces of machinery each with the initial purchase price of $100,000 and half of their lifecycle remaining, the total book value of those assets is $150,000.
Comparative method is based on the assumption that we know a good comparative entity and also its worth has been disclosed (commonly an entity listed at stock market), but it’s deficiencies also rise from previously given - commonly we don’t have a good 1:1 comparison and also pricing at stock market could be over- or underestimated.
Option pricing method is a complex valuation model applied in case there is some uncertainty concerning future events and management can flexibly react to them after their emergence.
The last and evidently the most applied one in practice is Discounted Cash Flow model (DCF), which is viewed in more detail as follows. DCF-method and its formula are based on company’s cash flows and depending on specific model the calculation of cash flows varies. When we want to determine the value of a business, neglecting the source of capital, we can apply free cash flow to firm (FCFF) approach. When we want to determine the value of equity, i.e. the worth of firm only for the owners or equity holders, we are talking about FCFE valuation. A central concept in DCF-equation is discount rate, which in case of FCFF is WACC (Weighted Average Cost of Capital, whereas both, cost of equity and cost of debt are used as input) and in case of FCFE is only cost of equity (i.e. owners’ required rate of return). The FCFF is calculated by the formula:
[EBIT × (1 – Corporate Tax Rate) + Depreciation – Changes in Working Capital – Capital Expenditure]
And for determining the firm value, discounted FCFF amounts for all viewed years are summed. The calculation of discounted FCFF works in a way that for each year t, FCFF will be divided by (1+WACC)^t (see the following example). In case firm’s activities will not be terminated in the future and we consider the business infinite, then discounted cash flows are normally calculated for up to five first years, but for the remaining period terminal value (also called as residual value) is calculated based on the assumption of some average cash flow (with certain annual growth) for all forthcoming years. For long-established businesses with fixed market share the approach where annual cash flows are not different could be applied at once, whereas in case of companies which have rapid growth (e.g. startups) it is highly likely that cash flows are uneven for first activity years.
In this video, Jason Greene discusses the Discounted Cash Flow Model as an approach to estimating the intrinsic value of a company's stock. He reviews the theoretical motivation behind the model and the model's required inputs, assumptions, and forecasts.
A simple example of FCFF calculation would be the following. Suppose we have a company where there are no changes in working capital, no investments, tax rate equals zero and the only important variable is operating cash flow $100,000 per year and discount rate (WACC) is 10%. In such simplified case the business value would be calculated with the formula:
As can be seen from the previous equation, in case the company witnesses same cash flows over its whole lifecycle, the worth of business can be calculated as the cash-flow divided by discount rate. Such calculation is sometimes referred to as capitalization of earnings and besides free cash flow to firm easily obtainable figures from profit statement have been applied.
For instance EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), Net Income and SDE (Seller’s Discretionary Earnings) have been commonly used figures. As a number divided by some discount rate can also be expressed as the same number multiplied by a certain figure (e.g. division with 20% (i.e. 0.2) is the same as multiplication by 5), then in practice sophisticated valuations are often avoided and instead a simple method of multiplying EBITDA or SDE with 3-6 has been applied in valuation. Although not methodologically backed, such rule of thumb has been widely applied.
The previous discussion argues that discount rate has a high impact on valuation result and the application of substantially different discount rates can lead to several-fold differences in business valuation. Also, risk and discount are directly related to the simple fact that as business-related risk increases, the required discount rate (i.e. the required rate of return) increases accordingly. Other things equal, riskier businesses such as start-ups tend to yield with a lower valuation.