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Most Used Methods To Value Your Company

Valuation of companies

When an entrepreneur thinks about selling a company, merging it, splitting it or simply determining its value on a given date, letting managers know the position of the company vis-a-vis the economic sector that is shared, different methods and tools are used but in many cases are not appropriate for the intended purpose.

The valuation of companies, like any financial tool, is one of the factors that intervene in the decision to buy, sell or negotiate an asset between two interested parties.

Conceptually, it is understood as a process by which values are assigned to events or economic events, according to rules, with particular purposes to inform the investor of the recovery of their capital in the present, considering variables that allow determining their value in time.

Why value a company?

There are several reasons why employers want to value their company; the following list shows the main points of interest of an entrepreneur:

  • Know how much it costs (company, business, property or other asset)
  • Know the distribution of an inheritance
  • Wanting to grant or obtain guarantees
  • To grant or request financing
  • To make alliances
  • To buy a company (in parts or complete)
  • To sell a company

The approaches used are of 3 types:

  • Cost approach: Based on the idea that a conservative investor would not be willing to pay an asset more than the cost of replacement or production of it. This approach is related to accounting methods.
  • Market focus: It seeks to estimate the value of a company based on comparable of companies which were purchased under similar conditions. It is related to the method of valuation by multiples.
  • Income approach: Mainly focused on the discounted cash flow method. This is the most commonly used financial method.

 
What are the most used methods to value companies?
analisis financiero

There is a set of methods whose purpose is to justify the value that is willing to negotiate on the asset.

  1. Accounting Methods:
    • Patrimonial Accountant: relation of the value of the company and its equity with values of the accounting book of the company. (Due Diligence process)
    • Regularized Accounting Value: The total of assets at book value less the liabilities payable by the company (accounting equity). Various adjustments can be applied (inventory write-offs, uncollectible items, etc.)
    • Liquidation value: The accounting equity is taken into account at liquidation value, the value of the assets of the company in the market, together with the costs of the cessation of activities, are estimated.
    • Substantial value or replacement: Estimate what a company would cost to start building the asset needed for your business today.

 

One of the advantages of this method is that they are easy to estimate and apply, in addition they can be justified with accounting documents and a static valuation of the company is carried out. On the other hand, the disadvantages come to be, that it does not consider the expected future, no taking into account the value of money over time, nor the flows that are generated in the future, among others.

  1. Capital Gain Methods: Assumes that the value of the company is equal to its net assets plus goodwill.
  • Classic Method
  • Double Rate Method
  • Indirect Method
  • Purchase of annual results
  • Union of European Accounting Experts
  • Capitalization of Benefits
  • Direct

They are a set of combination of accounting values (or replacement cost) accompanied by surplus value, which is calculated in different ways. It is used interchangeably, interest rate with and without risk, it also mixes the static with the dynamic, and finally, seeks to justify the value of the price you want to prevail in a negotiation..  

  1. Methods based on dividends:
  • Profit method: This method calculates the present value of perpetuity in which the established flow is the profit, which may be current or future, and “r” is the desired rate of return.
  • Dividend yield method: This method calculates the present value of perpetuity in which the established flow is the dividend paid by the company (which is assumed constant), and “r” is the desired rate of return.
  • Gordon and Shapiro Method: This method calculates the present value of perpetuity in which the established flow is the dividend paid by the company (which is assumed constant), “r” the desired rate of return and “g” the constant growth rate (strong assumptions).


The conceptual basis of these methods is that the book value of equity, do not relate to their real (market) value; that is, the book value does not express the value that capital have for shareholders, which is really what the market is willing to pay for them according to profits, benefits, or dividends.

The main assumption of the methods based on dividends is that the benefits and dividends are constant and unlimited over time.

  1. Method based on financial multiples:

It is based on the observation made of a company, through the application of various indicators, especially the stock market of companies with similar characteristics to obtain a value associated with it.

  1. Value in the stock market:

It consists in taking as a basis the stock price of the shares of a company at a certain moment, or its average during a given period, and calculating the value of the company taking the number of shares in circulation multiplied by the price of the share. It has acceptance if the market shows high volatility and volatility.

  1. Discounted Utility:

The technique used in this method is to project the income statement of the company, to know its net profits in the next 5 years. This requires the estimation of income, costs and expenses responding to a trend of the economic, social, political future of the country, the behavior of the market that is shared and the expected demand. The growth of the company, the economic indicators, the application of internal policies in the matter of working capital, financing structure and the capitalizations are considered if necessary.

  1. DCF method (discounted cash flow):

Most used method, and it is understood that "the company is worth what it is capable of generating through a defined time frame, plus the value of the uncalculated time frame" [1].

This method seeks to predict a monetary flow of incomes and expenses during the probable life of the company or a project, which are subsequently discounted at the capital cost rate of the company, thus reflecting the value of the money in the time and the degree of risk of the flows.

The cash flows generated by the companies will be obtained from their operating activities, considering the physical, intangible and working capital investments.

  1. FCL Method (free cash flow):

It is the tool that shows us the cash flow available to shareholders generated by a company as a business itself during a period. It is the closest to the cash or cash flow. It comes from the EBIT minus the tax associated with the profits deducted from the debt service, the fixed assets to support the operation and the working capital needs, considering amortization and depreciation.

It is called free cash flow (FCL) because it is free of the effects of financing including the savings in taxes for the cancellation of interest.

[1] https://www.aiu.edu/applications/DocumentLibraryManager/upload/valoracion%20de%20empresas.pdf

 

What steps should you follow in the discounted cash flow?

flujos

Conclusions

The methods described have their advantages and disadvantages. Today, those based on discounting future cash flows and multiples of comparable companies are used with greater interest because they are related to the generation of funds in the future of companies.

 

Sources:

For the realization of the article the following sources related to the valuation of companies have been taken into account::

  • Alberto Parra Barrios: " Valuation of companies: Valuation methods "
  • Eduardo Estay G: "Valuation of companies" - Atlantic International University

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