What’s worse than buying something, only to realize that you got ripped off? Not much. Now imagine that scenario on a large scale, such as overpaying for a business. That could be a significant problem.
But how do you assess valuation, and which methods are most effective? Why would a business executive need to assess their company’s valuation? These are the questions we asked in an interview with Leon Grady, an investment banker at Armillary Private Capital in Wellington, New Zealand. Leon was kind enough to let us in on the world of company valuations. He shared company valuation methods and the importance of understanding company valuations.
Discounted Cash Flow (DCF) Method
DCF is considered the golden standard for valuations and is widely used. Discounted cash flow is a method that uses discounted future cash flow projections to estimate the present value of an investment. Following the DCF method, you are trying to figure out the current value of the cash that the company will generate in the future.
Using the DCF method, having financial acumen is extremely important. You must understand the time value of money because a dollar in the future is not worth the same as a dollar today. Knowing the difference between cash and profit will also be helpful as the calculations use cash, not profit.
Comparable Company Analysis (CCA) Method
The comparable company analysis method compares the business you want to evaluate against its competitors in the industry. The method compares the companies across various areas using statistical data. Looking at a company’s data’s median, upper, and lower quartiles can help you measure where it stands compared to its competition. It can also help identify areas for investment opportunities. To understand financial company data, you will need financial acumen and be well versed in the language of finance.
A few other variables factor into CCA. Public and private companies are accounted for differently; you apply a liquidity discount for private companies. You can then arrive at a new set of discount rates that paints a good picture of where the company’s valuation stacks up to its competitors.
Determining the value of a can of Coca-Cola is an excellent analogy for the CCA method. You can buy it in various places: a grocery store, a ballgame, a gas station, etc. Each one of these places will sell the can at a different price. Many factors come into play here (e.g., economies of scale, location, demand), but by comparing how much a can costs across many different vendors, you can gauge the value of a can of Coca-Cola.
Future Maintainable Earnings (FME) Method
Future maintainable earnings as a valuation method is similar to discounted cash flow, but this method can be more useful in smaller companies with less available information.
The idea behind the method is to see how a company has performed financially versus their budget to predict how well it will do in the future. If a company is consistently over or even under budget, it means they do not have a grasp on the future performance of its business.
First, take a few historical years as a basis. Then, take the current year’s data and project it through the end of the current year (assuming no major changes). With financial acumen, you can use this data to predict how the company will perform in the future and even weigh specific years’ data differently.
Which Company Valuation Method Is the Best?
There is not one method that is the best as it depends on the industry of the company in question. But, using multiple valuation methods is optimal because you will have various data points and be less likely to accept an outlier as the actual valuation.
If you use the three methods above, you could take the mean of your three values. But if you use five or more valuation methods, you could always throw out the highest and lowest values to give yourself a more accurate valuation.
Why All Employees Need to Know How to Assess the Value of a Business
Before investing in, selling, or changing a business, it is best to be prepared with as much knowledge as possible to make the right decision. And part of the knowledge employees will need is how to assess the value of a company.
Making the right business decisions can be difficult, especially when you don’t have the right tools. All employees need financial acumen for teams to communicate with each other and achieve company-wide financial results.
Income|Outcome offers business management simulations that have helped tens of thousands of employees worldwide develop their business and financial acumen. With newly learned skills from Income|Outcome, senior-level employees can better understand key financial concepts. Following the business management simulation, they will be equipped to make better business decisions when significant and strategic opportunities present themselves.