There are several methods which are used to value companies. The predominant problems with these historical methods are listed below:
Business Valuation Methods and Formula
Book Value. Total assets minus total liabilities. This method however, ignores the future return the assets can produce and is calculated using accounting practice that does not reflect how much the business is worth to someone who may buy it as a going concern.
Market Value. (for quoted companies only). Is derived by multiplying the quoted share price of the company by the number of issued shares. This valuation reflects the price that the market at a point in time is prepared to pay for the shares. It is therefore influenced by the condition of the stock market, the concerns and opportunities that are seen for the company in the sector or market in which it operates. Also the investor's view of the ability of management to deliver a return on the capital he or she is using. It may anticipate some of the synergies that acquisition may bring, but is likely to have less of a grasp on the potential as a buyer from the same industry. For companies not listed on stock markets there is obviously no group of investors setting a value on the business on a day to day basis.
Discounted cash flow method. DFC uses the future free cash flow of the company (after all liabilities have been met) discounted by the firm's weighted average cost of capital (the average cost of all the capital used in the business, including debt and equity), plus a risk factor measured by beta. Beta is an adjustment that uses historic data to measure the sensitivity of the company's cash flow, for example, through business cycles. This means that companies in highly cyclical businesses will have a high beta to reflect the volatile nature of their cash flow. The DCF method is a strong valuation tool, as it concentrates on cash generation potential of a business. However, the risk factor, measured by the beta, is impossible to measure precisely. 4. Price-earning ratio. (PE ratio). This is a popular method due to its simplicity. For non-listed companies wishing to use this method, a comparable quoted company/sector should be used. The difficulty here is in the selection of a comparable company. There could be differences in accounting methods (i.e. treatment of intangible assets like R&D) or an artificially boosted PE ratio due to an atypical drop in earnings. Among many investment professionals, use of accounting net earnings for valuation has declined in favour of cash-flow measurements which are seen as cleaner figures less influenced by the vagaries of accounting practice.
Profit/sales multiple. This method is sometimes used to value the SME sector by multiplying a years gross/net profit or sales by a certain number, determined as the appropriate multiple for the type of business. This approach particularly with the small and medium sized business has little or no scientific methodology behind it, as it assumes automatically that what has gone before will continue in the future.
