Companies are complex and their value is primarily determined by corporate planning and accounting. Last but not least, it is influenced by tax considerations. Companies should therefore be regarded as a purposeful combination of material and immaterial values. As a result, a company's value cannot be derived just from individual components such as assets and liabilities. The aim of the valuation is to determine a single monetary value for all areas of the business.
When is it necessary for a company to be valued?
In disposals and acquisitions, the question as to the company's value automatically arises. For purchase or sale negotiations, in which the price is basically determined by supply and demand, the company value is an important starting point for discussions. In many other cases, such as in the event of co-owners, inheritance, or the withdrawal of corporate partners, the value obtained by a proper valuation applies directly. However, the company's value can also represent a current and ongoing objective of corporate governance.
How is the value calculated?
The assessment is based on income (or cash flows) that can be generated with the company currently and in the future. For this purpose, it is recommended to have a budget in place for the coming years. In order to determine a company value that comes closest to the market value, budgeting assumes the continuation of the business and must take into account the existing market opportunities and market risks.
The actual cash value is calculated from the generated income or the cash flows by means of discounting annuities. In this context, risk discounts and possible proceeds from the sale of non-operating assets, etc. must also be taken into account.
An investor would ask: How much return (= profit) do I get if I invest in this company compared to the interest that the bank would pay me?
The value of your company will be influenced by a variety of factors. The best approach for the individual case must be selected from a series of alternative valuation methods.
Earnings Value Method (Income Approach) and Discounted Cash Flow Method
The two most important methods are currently the Earnings Value Method and the Discounted Cash Flow Method (DCF).
When determining the company value with the presented methods, only the financial situation is evaluated.
The focus is on the future. Future surpluses (profits) are calculated and then discounted to the present value as at balance sheet date.
At the end, both methods must produce the same value (provided that the same assumptions are made). The central question is: Is it better to invest money into the company or, instead, into alternative capital assets? In these considerations, the interest rate of an alternative investment (without risk) is used. A possible starting point in this respect would be the yield on a long-term government bond, for instance. In order to establish the equivalence of the alternative investment with regard to the risk, purchasing power and availability of the company to be assessed, increases and reductions must still be taken into account.
What is essential is that the future profits / cash flows are discounted and the present value is determined. Certain risks are taken into account in the interest rate.
The difference between the two methods
The Earnings Value Method is used to evaluate the calculated future profit (future success), as opposed to the DCF method, which takes the calculated future cash flow into account.
Earnings Value Method
Determines the company value as the present value of future cash inflows. In other words: A budgeted profit and loss account is created, the resulting future surplus revenues are discounted.
The Discounted Cash Flow Method is normally used for the valuation of capital companies. With this method, future cash flows are capitalised. The cash flow corresponds to the excess of operating revenue over expenditure. The future cash flow is estimated.
A distinction is made between the net (equity) and the gross method (entity).
Gross Method: The market value of all cash flows received minus the market value of the interest-bearing borrowed capital.
Net Method: Instead of taking the entire cash flow into account, only the payments made to the equity providers (e.g. dividends, withdrawals, capital repayments, etc.) are considered.
Wolfgang Dibiasi serves as a lecturer at Danube University Krems in the field of business valuation and has compiled corresponding lecture notes. If you would like a copy of these notes, please contact our office at firstname.lastname@example.org.