Determining a company’s value: rules of thumb, profitability value, and intrinsic value explained

You usually determine a company’s value based on rules of thumb (multiples) and historical figures, such as 4x EBITDA or 5x net income. The downside: these methods focus primarily on the past and pay little attention to your business’s future earning potential—and for a buyer, that’s really the only thing that matters.

In a business acquisition, both the seller and the buyer want to determine the value of the company in question. However, Waarde is a subjective concept.

Waarde is often determined by personal perspective (an Ajax season ticket is worth more to a soccer fan than to a basketball fan) and by circumstances (a glass of water is probably worth more to someone who’s been wandering around the desert for three days than to someone ordering an espresso on a patio).

What is the difference between a business’s value and its price?

The value of your business is a (subjective) estimate of its potential price. The price is the amount the buyer actually pays after negotiations. Waarde and price are therefore two different concepts—and it’s important to understand that difference before you start negotiating.

The fact that the seller usually has a higher value in mind than the buyer already shows that this is a matter of perception and not an objective truth. The value you calculate serves as the starting point for your negotiations.

The price is influenced by various factors: the seller’s financial position, the level of competition among prospective buyers, the buyer’s financing arrangements, tax implications, the bargaining power of both parties, and—last but not least—emotion: how eager is the buyer, and how eager is the seller?

To arrive at a somewhat objective valuation, various standard methods are used in practice. These methods primarily use historical (accounting) figures from the company’s records and financial statements as a starting point.

The advantage: this quickly provides an initial indication of the value. The disadvantage: the business’s future—which is what the buyer is primarily interested in—is not taken into account, or only to a very limited extent. These methods yield an accurate result only by chance and largely disregard future earnings.

Which three methods do you use to determine a company’s value based on historical figures?

In practice, these three valuation methods based on historical (accounting) figures are the most commonly used:

1. Rules of thumb
2. (Improved) profitability value
3. Intrinsic value

Below, we’ll take a closer look at each method.

1. How do you calculate a company’s value using rules of thumb?

In small and medium-sized businesses, rules of thumb (also known as multiples ) are widely used to determine a company’s value. These include formulas such as:

• 5 x net profit
• 0.75-1.5 x annual turnover
• 1 x net asset value + 2 x net profit
• 4 x EBITDA
• 5 x EBIT

This list can be expanded indefinitely to include other values and variables, such as the value per regular customer or subscriber. Within an industry, a consensus often emerges regarding which rule of thumb applies to that market. For example, an accounting firm is worth relatively more than a cleaning company, even with the same revenue. Rules of thumb, therefore, do not represent a universally applicable “truth” that applies to all businesses or industries.

A rule of thumb provides guidance when determining a company’s value. If it is customary in an industry to use four or five times net income as a starting point, this provides an initial indication of the value. All else being equal, a value of five times profit means that the buyer, due to higher financing costs, will have to operate for more than five years to recoup the cost of the acquisition.

And that’s without even considering that the payment is made “today,” while the profits won’t be realized until the coming years. If the buyer wants to shorten the payback period, they’ll have to grow the business.

What are the drawbacks of rules of thumb?

Rules of thumb are simple, but they also have drawbacks—especially from the buyer’s perspective. The three biggest ones are:

• Discussion of the concept of net income. Annual figures are usually adjusted—often in favor of the seller—which means the formula is applied to inflated figures.

• Rules of thumb are based on historical figures. Future profits are assumed to be equal to the average of recent years. But past profits are no guarantee of future performance—especially if the seller has been a key factor in the company’s commercial success.

• Rules of thumb ignore the specifics of a business. How dependent is the business on its owner? Is there a lot or little debt capital in the business? Are major investments needed in the short term?

These drawbacks mainly affect the buyer, but a rule of thumb can also work against a seller. This is particularly true for fast-growing businesses: in the past, profits were low because the business was in its startup phase, but in the coming years—as the business gains momentum—profits are expected to be much higher. A rule of thumb takes little or no account of this future scenario, resulting in an undervaluation. In short: there are quite a few drawbacks to this method.

2. How does the (improved) profitability value work?

With valuation according to the profitability value, you are already looking a bit more into the future. It is a simple way to determine the present value of the expected profit. This calculation involves two steps:

• First, you determine the “normal” profit based on average, normalized past profits and future expectations.
• Then divide this profit by the required return on equity.

This required rate of return is often based on the interest rate on a long-term risk-free investment plus a premium for industry and business risk. The higher the required rate of return, the lower the value of the company.

Clearly, the interests of buyer and seller do not run parallel in this method. Discussions can also arise about the amount of "normal" profit used in the formula.

What is the improved profitability value?

A variation on the normalized profitability value is the so-called “enhanced profitability value.” This variant takes into account the buyer’s desired debt-to-equity ratio for the business being valued. The higher the proportion of debt in a business—that is, the higher its debt burden—the less it is worth.

3. What is a business’s intrinsic value?

Net asset value indicates the value of a company’s equity: the total value of buildings, machinery, inventory, cash and cash equivalents, and similar assets, less its liabilities. The book value of equity serves as the starting point; hidden reserves and deferred taxes are then adjusted accordingly.

Intrinsic value is merely a snapshot in time, which makes this method less suitable than other, dynamic methods. It also cannot be determined entirely objectively, because the figures can be influenced in many ways.

The value of fixed assets is determined by depreciation periods, residual value, and accounting policies. By “playing around” with these variables, the company’s intrinsic value can be boosted. Reducing provisions (debt) also leads to an increase in equity.

For which businesses is intrinsic value a suitable metric?

Another drawback is that intrinsic value only reflects the value of the assets, but not the potential to generate revenue with those assets—and therefore says nothing about goodwill. For a healthy, growing company, you can consider the intrinsic value to be the company’s minimum value.

Determining a business’s value based on its intrinsic value is therefore particularly useful for underperforming businesses facing continuity issues, which have no goodwill.

Frequently Asked Questions About Determining a Company’s Value

What’s the difference between the value and the price of my business?

Value is a subjective estimate of what your business might be worth and serves as the starting point for negotiations. The price is the amount the buyer actually pays, influenced by financing, competition among buyers, tax implications, and emotion. Therefore, Waarde and price often do not correspond one-to-one.

What rule of thumb applies to my industry?

There is no universal rule of thumb: each industry has its own consensus, such as 4x EBITDA, 5x net income, or 0.75–1.5x annual revenue. An accounting firm is generally worth more than a cleaning company with the same revenue, because the rule of thumb varies by sector.

Why do rules of thumb often underestimate the value of a fast-growing business?

Rules of thumb are based on historical profits. For a fast-growing business, past profits were low due to the startup phase, while profits may actually rise significantly in the coming years. Because the rule of thumb does not take that future scenario into account, the calculated value often ends up being too low.

When should you use intrinsic value to value a business?

Net asset value—equity minus debt—is particularly useful for struggling businesses facing continuity issues and lacking goodwill. For a healthy, growing business, net asset value is considered more of a minimum value than a realistic selling price.

How do you calculate a business’s value based on profitability?

Divide the normalized “normal” profit by the buyer’s required rate of return. With a normal profit of 600,000 euros and a required rate of return of 15%, you arrive at a value based on profitability of 4 million euros; with a required rate of return of 20%, that value drops to 3 million euros (-25%).