Here’s a look at six business valuation methods that provide insight into a company’s financial standing, including book value, discounted cash flow analysis, market capitalization, enterprise value, earnings, and the present value of a growing perpetuity formula.
1. Book Value One of the most straightforward methods of valuing a company is to calculate its book value using information from its balance sheet. Due to the simplicity of this method, however, it’s notably unreliable. To calculate book value, start by subtracting the company’s liabilities from its assets to determine owners’ equity. Next, exclude any intangible assets. The figure that you’re left with represents the value of any tangible assets the company owns. As Harvard Business School Professor Mihir Desai mentions in the online course Leading with Finance, balance sheet figures can’t be equated with value due to historical cost accounting and the principle of conservatism. Simply put, relying on basic accounting metrics doesn't paint an accurate picture of a business's true value.
2. Discounted Cash Flows Another method of valuing a company is with discounted cash flows. This technique is highlighted in Leading with Finance as the gold standard of valuation. Discounted cash flow analysis is the process of estimating the value of a company or investment based on the money, or cash flows, it’s expected to generate in the future. Discounted cash flow analysis calculates the present value of future cash flows based on the discount rate and time period of analysis. Discounted Cash Flow =Terminal Cash Flow / (1 + Cost of Capital) # of Years in the future the benefit of discounted cash flow analysis is that it reflects a company’s ability to generate cash. However, the challenge of this type of valuation is that its accuracy relies on the terminal value, which can vary depending on the assumptions you make about future growth and discount rates.
3. Market Capitalization Market capitalization is one of the simplest measures of a publicly-traded company's value, calculated by multiplying the total number of shares by the current share price. Market Capitalization = Share Price x Total Number of SharesOne of the shortcomings of market capitalization is that it only accounts for the value of equity, while most companies are financed by a combination of debt and equity. In this case, debt represents investments by banks or bond investors in the future of the company; these liabilities are paid back with interest over time. Equity represents shareholders who own stock in the company and hold a claim to future profits. Let's take a look at enterprise values—a more accurate measure of company value that takes these differing capital structures into account.
4. Enterprise Value The enterprise value is calculated by combining a company's debt and equity and removing the amount of cash it's currently holding in its bank accounts (since it’s not part of its actual operations). Enterprise value can be calculated by adding debt to equity and subtracting cash. Enterprise Value = Debt + Equity - Cash To illustrate this, let’s take a look at three well-known car manufacturers: Tesla, Ford, and General Motors (GM).In 2016, Tesla had a market capitalization of $50.5 billion. On top of that, its balance sheet showed liabilities of $17.5 billion. The company also had around $3.5 billion in cash in its accounts, giving Tesla an enterprise value of approximately $64.5 billion. Ford had a market capitalization of $44.8 billion, outstanding liabilities of $208.7 billion, and a cash balance of $15.9 billion, leaving an enterprise value of approximately $237.6 billion.
Lastly, GM had a market capitalization of $51 billion, balance sheet liabilities of $177.8 billion, and a cash balance of $13 billion, leaving an enterprise value of approximately $215.8 billion. While Tesla's market capitalization is higher than both Ford and GM, Tesla is also financed more from equity. In fact, 74 percent of Tesla’s assets have been financed with equity, while Ford and GM have capital structures that rely much more on debt. Nearly 18 percent of Ford's assets are financed with equity, and 22.3 percent of GM's.
Hope this helps
KCN Price at posting:
$1.79 Sentiment: Buy Disclosure: Held
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