Financials – Valuing a Company

Another key element is the valuation of a company. In this piece, I want to discuss the various types of valuations you can conduct. These include asset-based, market-based, earnings-based, and cash flow-based methods. The choice of method often depends on the information available.

1. Asset-Based Valuation: This method can involve looking at the book value of the company's assets or making modifications to this figure. You might adjust the book value to account for differences between it and the current market value and consider any elements that shouldn’t be included. This approach sets a floor price based on the worth of the company's assets. You can also assess the replacement value or the liquidation value of these assets. The aim is to determine what the company is worth according to this selected method.
2. Market-Based Valuation: This approach is often based on price-to-earnings ratios of comparable firms and after-tax net incomes. It's easier to implement for public companies because of readily available data, but it can be challenging for private companies due to a lack of comparable data.
3. Earnings-Based Valuation: This method values the organisation based on normalised earnings, which are divided by the capitalisation rate. It’s essential to exclude any items that shouldn't be included in the earnings figure. The capitalisation rate reflects the riskiness of the business and can vary; for instance, it might be 15% for a small, stable business and 50% for a business where assets are at high risk.
4. Cash Flow-Based Valuation: This corporate finance method assesses the business based on its cash-generating ability. It involves forecasting future cash flows and discounting them back to present value. A significant challenge here is the predictability of these cash flows. You'll also need to consider the discount rate and the risk premium involved. For instance, the risk premium for an established business might be 6% to 10%, while it could range from 11% to 15% in a more competitive environment. For a small, cyclical business, the risk premium might be as high as 21% to 25%.

There are also some "rules of thumb" for quick valuations of specific types of firms. For example, private firms may be valued at three to five times EBITDA or one and a half to three times cash flow. Accounting firms may be valued at 100% to 150% of annual revenue, while bookstores might be assessed at 50% of annual sales plus inventory. Law practices can fall between 40% and 100% of annual fees.

When assessing a company, it's essential to consider various factors that could affect its value. In owner-managed businesses, there is often a "my baby" premium, where the owner believes the business is worth more than it actually is. Non-quantitative factors also play a role, such as industry attractiveness, potential legal or environmental issues, existing or pending union contracts, strategic alliances in the supply chain or distribution channels, and the company’s location relative to competitors. These considerations can significantly impact the ultimate valuation. This list of factors can go on and on.