Valuing a company is not a mechanical calculation or a universal formula. It is a demanding process that combines several perspectives on a company, namely its performance, future potential and asset base. Therefore, in practice, three basic valuation approaches are most often used:
- Market method (EBITDA multiples)
- Earnings method (DCF)
- Equity method
Each of them describes the value of a company in a different way and for a different purpose.
Market method, or so-called EBITDA multiples
The market method is based on comparing a company with other, similar companies that have been sold or are traded on the market. Its logic is simple. The value of a company is derived from how much investors are willing to buy comparable companies for.
The main input is EBITDA, which is first adjusted for one-time and non-standard effects so that it best reflects long-term operating performance. A market multiple is then applied to this normalized EBITDA (in the Czech Republic, on average x5), the amount of which reflects, for example, the business sector, the size of the company, the stability of results, risk, cash flow status and the degree of dependence on the owner or key people.
It is typically used for the needs of a faster indication of value, comparison with the results of other methods and when negotiating the price when selling a company.
Advantage of the method: Good connection to current market reality
Disadvantage of the method: Limited ability to capture the individual potential of a specific company
Income method – discounted cash flow (DCF)
The income method looks at the company as an investment and evaluates it according to its ability to generate money in the future. It does not work with past results, but with an estimate of future development.
The basis is a financial plan that describes expected sales, costs, investments and changes in working capital. Free cash flows are derived from these data, which are then converted to present value using a discount rate. This rate reflects the riskiness of the business, the capital structure and the investor’s expected return.
It is typically applied to growing and stable companies and is used as a basis for strategic decisions and investor entry. It is a key basis for financial investors.
Advantage of the method: The most comprehensive and economically purest view of value
Disadvantage of the method: High sensitivity to the quality of input assumptions
Asset method – net asset value
The asset method is based on the view that the value of a company is determined by the value of its assets after deducting all liabilities. It does not address the earning potential, but the current state of assets and liabilities.
Book values are usually adjusted to fair market values, especially for significant items such as real estate, machinery, technology or inventory. The result is a value that represents the so-called “hard” value of the company.
It is typically used for companies with a high proportion of tangible assets, for companies with unstable or low profitability, during liquidation or restructuring, and also to determine the minimum value of the company.
Advantage of the method: high defensibleness and transparency
Disadvantage of the method: ignores future earning potential and overall economic performance of the company
At least 2 different valuation methods should be used for almost every valuation. And why?
Each method answers a different question:
- The market method tells how the market values the company today.
- The income method shows how much value the company can create in the future.
- The asset method determines what its minimum asset value is.
Different results are not a mistake, but important information. Only their joint interpretation allows you to determine a realistic and defensible value of the company.
If you are dealing with the sale of a company, the entry of an investor, the settlement of shareholders or just want to know the real value of your business, the right methodology or combination of methods will help you determine it more precisely.
