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If you frequently consume entrepreneurship-related content, you must have often heard the term ‘valuation of a company’. A company’s valuation is estimating a company’s or asset’s value. The goal of learning how to calculate the valuation of a company is to determine the price at which an owner would sell or a potential buyer would pay for a given asset.
Estimating business valuation is the first step in determining how much to offer a company, whether buying or selling it. Valuation helps you determine how much money you can raise by issuing stock or debt securities, and it helps you decide how much cash flow to reinvest in your business or distribute as dividends.
The term “enterprise value” can have different meanings for different investors. According to the Corporate Finance Institute, Enterprise Value (EV) is the measure of a company’s total value. For example, price is the most important thing for some investors when valuing a stock, while earnings are more important for others. Investors usually look at growth opportunities when valuing stocks because they want to know whether there will be any growth in the future.
In this blog, we will understand what is valuation, how to calculate the valuation of a company, along with the valuation of shares, what is enterprise value, and much more.
Methods for Calculating Company Valuation
There are several methods to find the valuation of a company, and each one is used for different situations. The most common methods to know what is the valuation of a company are explained in detail below:
Book value
Also known as the accounting value, this valuation method bases a company’s value on its accounting statements. The book value is determined by subtracting intangible assets such as goodwill, patents, and trademarks from total assets.
Book Value Calculation Formula:
Book Value = Total Assets – Total Liabilities
The market value approach estimates the market price of a company’s stock by looking at recent transactions in the stock market or other similar enterprises in the industry. This approach can also determine the worth of privately held companies without publicly traded stock available for sale.
The book value estimates the company’s intrinsic value by subtracting its liabilities from its assets. It represents the valuation of the assets of a company.
Discounted Cash Flows
DCF is another popular method you can opt for while learning how to calculate the valuation of a company. The DCF method is based on the principle that a business should be valued by its ability to generate cash flow over time. DCF analysis uses an estimated growth rate and discount rate to develop a valuation for the business. The growth rate is based on your projections of future cash flows, while the discount rate is based on what you expect to pay for similar businesses in the market.
DCF Calculation Formula:
DCF = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2) + … + (CFn / (1 + r)^n)
Here, CF represents cash flow, and r represents the discounted rate.
It’s important to note that the DCF method relies heavily on accurate cash flow projections and the appropriate discount rate selection. Small variations in these inputs can significantly impact the final valuation.
Market Capitalization
When determining the valuation of a company, analysts consider multiple measurements, including the company’s market capitalization. Market capitalization is calculated by multiplying the number of shares outstanding by the share price.
A company’s market capitalization can also be called its “market cap.” This figure represents how much investors think the company is worth based on its share price and stock trading volume.
One can find the value of market capitalization with the formula:
Market Capitalization = Shares Outstanding x Share Price
This figure helps investors determine whether to invest in a company’s stock. The higher the market cap, the more expensive it is for investors to purchase shares in a company (and vice versa). Market capitalization does not consider a company’s debt or other financial metrics, so evaluating other valuation methods and financial indicators is essential for a comprehensive analysis.
Enterprise Value
Enterprise value, or EV, determines what the enterprise value of your company is. It equals the market capitalization, total debt, and minority interest minus cash and cash equivalents. The enterprise value can also be considered the price at which an acquirer would buy a company since it is the price that would be paid for all of its outstanding shares, plus the assumption of any debt.
Enterprise Value Calculation Formula:
Enterprise Value= Market Capitalization + Total Debt – Cash and Cash Equivalents
Enterprise value has two main advantages over other valuation methods:
- It considers debt and equity, making it comparable to buyers’ purchase prices. Buyers pay more for companies with more debt than those with less. They also pay more for companies with more cash than those without cash.
- It reflects the value of all outstanding shares (“market cap”), including restricted stock units (RSUs), rather than just trading shares available for sale (“free float”). This is important because most companies have employees who hold some form of a restricted stock grant that cannot be sold immediately but whose value can be determined.
Comparing a company’s Enterprise Valueto its operating performance metrics, such as revenue, earnings, or cash flows, can help assess whether the company is overvalued or undervalued about its financial obligations.
EBITDA
EBITDA is one of the most commonly used metrics when learning how to calculate the valuation of a company. It stands for earnings before interest, taxes, depreciation, and amortization. It is also known as operating cash flow or free cash flow.
EBITDA measures a company’s operating profitability by excluding non-operating expenses and non-cash items from its earnings.
EBITDA Calculation Formula:
EBITDA = Earnings + Interest + Taxes + Depreciation + Amortization
EBITDA is calculated by adding the net income from a company’s income statement and then subtracting interest payments on debt, depreciation, and amortization expenses from those profits.
For example, if a company earns $1 million in revenue and incurs $500,000 in operating expenses, its net income will be $500,000. However, if it incurs $400,000 in depreciation expense and $100,000 in amortization expense (both non-cash items), its EBITDA will be $900,000 ($1 million – $400K – $100K = $900K).
Price to Earnings Ratio
The price-to-earnings ratio is the most popular valuation metric. It compares a company’s stock price to its earnings. A higher P/E Ratio indicates that investors are willing to pay a premium for the company’s earnings, suggesting positive market expectations. Conversely, a lower P/E Ratio may indicate undervaluation.
The P/E ratio calculates the company’s share price by its per-share earnings or EPS. The formula looks like this:
P/E = Share Price / Earnings Per Share (EPS)
The number of shares outstanding is usually found in a stock quote or on a financial website like Yahoo! Finance or Google Finance. Different industries may have varying typical P/E Ratio ranges due to differences in growth rates, risk profiles, and other industry-specific dynamics.
Price to Sales Ratio
The price-to-sales ratio is the most basic of all the valuation ratios and is very simple to calculate. All you have to do is take a company’s market capitalization and divide it by its trailing 12-month revenues.
P/S Ratio Calculation Formula:
P/S Ratio = Market Capitalization / Total Revenue
For example, if a company has a $1 billion market cap and $500 million in trailing 12-month revenues, its price-to-sales ratio would be 2.5, which is considered fairly high. The higher the ratio, the more expensive the stock is relative to its revenue growth rate. This means that investors are paying more per dollar of earnings than before (or expect future earnings growth to slow).
Price to Book Value
The price-to-book ratio is one of the most common metrics for valuing shares. It’s simple to calculate and understand, yet it can be a useful tool for investors who want to evaluate the relative value of a company.
P/B Ratio Calculation Formula:
P/B Ratio = Market Price per Share / Book Value per Share
Therefore, a stock with a P/B ratio of 1 trades at its book value. A stock with a P/B ratio of 2 would trade at twice its book value, while a stock with a P/B ratio of 0.5 would trade at half its book value.
Price-to-book ratios are often used by investors who believe that companies with lower ratios are undervalued and could be worth more than they’re currently trading for.
Growing Perpetuity Formula
The growing perpetuity formula calculates a business’s value if it grows at a constant rate forever.
This formula is useful for projecting a company’s future earnings. Analysts and investors often use The growing perpetuity formula when they create discounted cash flow valuations.
The formula for Growing Perpetuity Valuation:
PV = C / (r – g)
Where:
PV = Present Value of the cash flows
C = Cash flow in the first year
r = Discount rate (required rate of return)
g = Growth rate of the cash flows
A sensitivity analysis should be conducted to understand the impact of different scenarios and assess the company valuation’s robustness.
Factors Affecting Company Valuation
How much is your company worth? The valuation of a business is the process of determining its worth. Several factors affect your company’s value. These are detailed below:
Financial performance
A company’s financial performance depends on its operating performance and ability to generate cash flows. If a company can meet its financial obligations, it will have fewer problems raising capital and generating profits.
A company’s financial performance can be quantified using ratios such as return on equity (ROE), return on assets (ROA), enterprise value to EBITDA, etc. These ratios help investors understand how well the management is running the business.
Industry and Market Trends
If the industry is growing at a fast rate, then there is a good chance that your company will grow at a fast rate too. Your company may not do well if the industry is shrinking or stagnating. The market trends also affect your company’s valuation since they impact sales numbers, directly affecting profits and capital gains.
For example, suppose you have a retail store that sells electronic goods, and people are buying more than usual due to low prices or discounts offered by various retailers in town. In that case, this will also impact your company’s valuation.
Management and Leadership
A strong, experienced, well-connected management team will help a company grow faster and increase its valuation. Management teams with experience scaling companies and leading them to success will have more credibility in investors’ eyes.
The value of a startup also depends on its leadership, especially if it’s a company that has raised capital before or has been around for some time. Investors want to invest in companies with proven leaders who have built successful companies.
Examples of Calculating Valuation
With the following examples, you can get a clearer idea of how to calculate the valuation of a company.
How to calculate the valuation of a company using market capitalization?
The most common method of calculating a company’s value is to use its current market capitalization.
This figure is calculated by multiplying the current price of a company’s stock by the total number of shares outstanding. For example, if a company has 1 million shares outstanding and each share trades for $100, then the market capitalization is $100 million (1 million x $100 = $100 million).
Calculating company valuation using the growing perpetuity formula
Let’s consider a company with an estimated cash flow of $1 million in the first year, a discount rate of 10%, and a projected growth rate of 5%.
PV = $1,000,000 / (0.10 – 0.05)
PV = $20,000,000
Thus, the present value of the company’s cash flow is $20 million.
Another example is calculating company valuation using the price-to-book value method:
Suppose a company has a market price per share of $50 and a book value per share of $40.
P/B Ratio = $50 / $40
P/B Ratio = 1.25
Therefore, the P/B Ratio is 1.25.
Conclusion: Building Valuation of a Company
When raising a round of funding, knowing your company’s value is important. Calculating a company valuation can be done through different methods. Ensure that your chosen method is appropriate for your industry, growth stage, etc.
Valuation is a complex topic that can be approached from many different perspectives. It’s important to remember that there is no “one size fits all” valuation model for startups. Even if you work in the same industry as another company, your valuations will likely vary because of how each business performs and how much growth potential each has.
Innovative, low-investment ideas for the hidden entrepreneur in you! Explore our guide on Business Ideas.
Frequently Asked Questions (FAQ’s)
The formula depends on the method used, such as P/E Ratio, DCF (Discounted Cash Flow), or market capitalization. Market Capitalization is calculated by multiplying the current market price per share by the total number of outstanding shares.
Shark Tank calculates valuation based on the company’s profit and revenue generated. These financial indicators play a crucial role in determining the value of a company pitched on the show.
The three common ways to value a company are through market-based approaches (comparing it to similar companies in the market), income-based approaches (evaluating the company’s income and cash flow), and asset-based approaches (assessing the company’s tangible and intangible assets).
The best valuation method depends on various factors, including the industry, growth stage, and available financial information of the company being valued. No single method is universally considered the best, and it’s important to consider multiple factors and employ different methods to arrive at a comprehensive valuation.
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