How to value a company

Company valuation

Firstly, there is no set way to value a Company. There are many different techniques, some more effective than others. What follows is an explanation of how I place a value on a Company.

Why do you need to be able to value a Company?

When investing, it is important to know what the true value of a Company should be. No matter how good the business is there is no point in paying an amount more than the business is intrinsically worth. The idea is that when investing you should make an assessment of the true valuation of the Company and only pay a price that is less than your valuation. Of course, this valuation is highly subjective. I would be surprised if two people made an assessment of the valuation of Tescos and calculated the exact same amount.

Valuation Example

For ease of explanation I will use the example of a small apple business. Let's say that you own one apple tree. Every year the tree grows 100 apples that you sell for £1 each to friends. 

What is the value of this business?

Willing to buy/ willing to sell
Some people may argue that the business is worth whatever someone else is willing to pay for it. A buyer may be willing to pay £100 for the apple business, calculating that he could make his money back within one year. However, you also need to be willing to sell the business for £100. You may reason that if you held onto the business for another year then you'd make £100 anyway, you may value the business as higher than £100. Another factor in your willingness to sell may be consideration of where else you could invest your money to earn you a return. If there are lots of other opportunities then it would seem more likely that you would sell at a lower price and invest the cash elsewhere. 

Value is the sum of the business component parts

Some people may argue the above, that a business is worth whatever we can sell each individual component for. In our example, this not only means the business would be worth the equivalent to selling all the apples, but also the value of each seed and the wood from the tree itself.

How would I value the apple business?

I reason that the business is worth the value of the profits over the next few decades. However due to inflation (among other factors) eroding the future value of my profits you need to discount the value of the future profits to today's value. I would reduce the profits by the potential interest that could be earned by investing the proceeds of the sale elsewhere. For example, we could sell the business and invest the proceeds into a Company in the FTSE100 paying a 5% dividend yield. In which case we would need to discount all future profits by 5% per annum.

Final valuation

Let's say that I would have been able run my apple business for the next 50 years upon which I would retire. Thus the future discounted profits are as follows:
Year 1 - £100
Year 2 - £95.2 (£100 X 1/1.05)
Year 3 - £93.4 (£100 X 1/(1.05)^2)

And so and and so forth until year 50...
Year 50 - £8.7    (£100 X 1/(1.05)^50)

In which case the total value of the business is simply the sum of all the cash we can make over the foreseeable future. In this case it would be £1,925.59. As such, the apple business should sell for no less than this amount.

The reason why so many analysts may come out with so many different valuations is because each analyst may discount at a different interest rate or may even have a rate that changes over the years. Furthermore, each analyst may assess the future cash flow of the business to be different. I have assumed that it will generate constant cash flow, however there is no reason why we couldn't predict the Company to have decreasing or increasing cash production over time.

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The Wallet Doctor said...

I've always been interested to hear how valuing a company really breaks down. I think its something more people ought to understand. Knowing what ought to be valued, and what should not, can lead to making other sound decisions.

Jacob Birtwistle said...

Management of the companies always know how to increase the value of their company. They should buy custom written papers to learn about how to increase the value of their company.