You determine a company’s value based on historical figures (such as rules of thumb or an EBITDA multiple) or based on future cash flows (the DCF method)—in practice, often a combination of both. The valuation method you use has a major impact on the final enterprise value, and it’s important to note that the enterprise value is not the same as the final sale price.
There are many situations in which it is important to determine a company’s value—such as an investment, a business transfer, or a dispute between two shareholders. The valuation method you use plays a crucial role in determining the final value of the company.
Content:
- Reasons to perform a valuation
- Determine enterprise value
- Methods to calculate enterprise value
- Pitfalls of an (Excessively) High Business Valuation
- Calculate your company value yourself
1. When should you determine a business’s value?
Calculating the enterprise value always plays a role in situations where shares are transferred from one party to another. Here you can think of:
- Merger, acquisition or business transfer;
- Shareholder dispute;
- Economic and fiscal disputes;
- Divorce;
- Inheritance.
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2. What is the difference between a business’s value and its price?
Especially in transaction practice—when it comes to selling a business or conducting a business acquisition—it’s often one of the first questions that comes up: What is the business worth? This question is difficult to answer, because there is no universally applicable formula for determining a company’s value.
Good to know: there is a difference between a business’s value and the price paid for it. A business’s value is a figure derived from a specific valuation method used to determine that value. The price is the amount paid by the buyer and is the result of a negotiation process. The price and the business value are usually not the same.
3. What methods are available for calculating a company’s value?
There are roughly two approaches to arrive at a company value: methods that mainly look at historical figures and methods that focus on future cash flows. There is something to be said for both methods, and in practice a mix of both is often used.
How do you calculate a company’s value based on historical figures?
This method for calculating the enterprise value mainly looks at the past. The advantage of this approach is that it quickly gives an initial indication of the business value. The disadvantage is that the future of the business - and that is what the buyer is primarily interested in, after all - is hardly considered, if at all. In general, this method of calculating enterprise value leads to simple formulas such as:
- 5 x net profit
- 0.75 - 1.5 x the annual turnover
- 3 x EBITDA (= earnings before interest, taxes and depreciation on fixed and intangible assets)
The major drawback of this method is that the business value is based entirely on past results. But just as with investing, these offer no guarantee for the future. Furthermore, it does not take into account other factors that can significantly influence a business’s value: How dependent is the business on its owner? Are major investments needed in the short term?
How do you calculate a company’s value based on future cash flows (DCF)?
This method for calculating the enterprise value mainly looks at the future earning capacity of the business. This method is called the discounted cash flow method(DCF method).
The DCF method does not focus on profit (an accounting concept), but rather on present-value future cash flows—the money that actually flows into the business. It also takes into account future investments, the launch of new products, the outsourcing of production, etc. The future cash flows generated by these factors are then discounted to present value at an interest rate consisting of a minimum required rate of return plus a risk premium.
To determine the risk premium we look at qualitative factors that influence the final company value:
- Dependence on management;
- Dependence on buyers and suppliers;
- Market position of the business;
- Distribution of entrepreneurial activities;
- Access barriers.
The DCF method not only provides insight into a company’s value, but also shows how that value can be influenced.
4. What are the pitfalls of an (excessively) high business valuation?
It is very tempting to dream of huge sales proceeds, and many sellers do just that. But without disappointing you, it is wise to take a moment to consider the following three pitfalls:
- Taking a one-sided view from the seller’s perspective
- What is the buyer's perspective?
- What about fundability?
#1 One-sided assumption of the seller's perspective
Their business has been turning a profit of two hundred thousand for years; they also take home a hundred thousand in management fees each year, and at the tennis club, they hear that their business is worth seven times its profit with ease. So they do the math: 7 × 300,000 equals 2.1 million euros, and they embark on the sales process with high hopes.
Conveniently, they forget for a moment that the buyer must also have a salary, so that ton of management fee must be excluded from the calculation. Then comes the next reality check: based on the characteristics of the business and the industry, it turns out that the business is not seven times, but at most four times the profit. And so the value drops from the hoped-for 2.1 million euros to 800,000 euros. Not exactly an amount to carefree retirement from.
Another common mistake is that sellers are too quick to brush off a few bad years. But a buyer will base their offer on the business’s current status and on what they can do with it, not on what it used to be worth. No matter what numbers you have in mind, no matter how impressive your calculations may be: in the end, there’s only one figure that really matters, and that’s the price the buyer is willing to pay for your business. That amount may well be a lot lower than the business’s “dream value.” You may think your business is worth five hundred thousand, but if the highest bidder is only willing to pay three hundred thousand, that’s the reality you’ll have to accept. Fortunately, the opposite can happen as well.
#2 The perspective of the buyer
Most valuation methods primarily assume the seller's point of view. After all, if you follow the methods obediently, you will base the future estimates needed to determine value on your own business plan. But for a buyer, what you intend to do with the business and what it is worth to you is really not relevant at all. No, a buyer wants to know what it is worth to him.
#3 What about fundability?
As a seller you can choose the highest value as a starting point for negotiations, although the question is whether that is always wise. As in the housing market, too high an asking price can also deter buyers. Especially in times when banks are cautious about providing loans, fundability is an important aspect in arriving at the purchase price.
You can have a well-founded asking price of 2 million euros on paper, but if the intended buyer with his own resources and a bank loan does not come beyond 1 million, that is still the reality with which you enter the negotiations. Insisting on 2 million cash for 100% of the shares is then rather pointless. To close the deal, creative solutions will soon have to be sought, such as a subordinated loan, phased sales, an earn-out arrangement and other variants.
It is therefore very important that you have a picture of the financial possibilities of the buyer as early as possible in the sales process.
Frequently Asked Questions About Business Valuation
When should you determine the value of a business?
You need a business valuation in any situation where ownership of shares changes hands, such as a merger, acquisition, or business transfer; a shareholder dispute; economic or tax disputes; a divorce; or inheritance.
What is the difference between business value and price?
Business value is a figure derived from a valuation method. The price is the amount the buyer actually pays and is the result of a negotiation process. The price and business value are usually not the same.
What are the two main methods for calculating a company’s value?
There are methods that focus primarily on historical figures, such as rules of thumb based on net income, revenue, or EBITDA, and methods that are based on future cash flows, such as the discounted cash flow (DCF) method. In practice, a combination of both is often used.
What is the biggest pitfall of an (excessively) high business valuation?
The biggest pitfall is relying solely on the seller’s perspective—for example, using an overly high multiple or including a management fee that actually represents the buyer’s salary. Ultimately, the only thing that matters is the amount the buyer is actually willing to pay, and that can be significantly lower than the desired value.
Why is the buyer’s financing capacity important in business valuation?
A well-founded asking price is meaningless if the buyer cannot finance the purchase with their own funds and a bank loan. To close the deal anyway, creative solutions are often sought, such as a subordinated loan, a phased sale, or an earn-out arrangement.
How can you quickly calculate an estimate of your company’s value yourself?
With Brookz free valuation tool, you can get an indicative valuation of your business in just 5 minutes.
5. Calculate your company value yourself
In order to calculate the value of your company, Brookz has developed its own company valuation tool which provides you with an indicative valuation of your business within 5 minutes!
