Confused about valuing a business? Read on for some top tips and advice on different methods from our Special Counsel Robert Toth.

Tangible v Intangible Assets

It’s important to understand the distinction between tangible and intangible assets to accurately value a business. Tangible assets such as property, office equipment, machinery or stock-in-hand can be readily valued. Intangible assets such as a brand, goodwill, intellectual property and future potential are more difficult to value. The longer the business has been operating, the better the financial history, cash flow and customers.

Business Valuation Methods

The true value of a business is what the market will pay you. However, there are some accepted valuation methods adopted and they are useful to know.

Price Earnings Ratio

This is the value of a business divided by its profits after tax. For example, a company with a share price of $40 per share and earnings per share after tax of $8 would have a P/E ratio of five (40/8 = 5).

The equation is: Value = Earnings after tax × P/E ratio.

Once you have the P/E ratio, you can use it to multiply the business’s most recent profits after tax by this figure. For example, using a P/E ratio of 5 for a business with post-tax profits of $100,000 gives a business valuation of $500,000. Some industries have ‘standard’ P/E ratios in their sector which can be used as an indicator.

Entry Cost Valuation

This reflects the cost to start up a similar business from scratch, such as:

• The cost to buy or finance assets
• The cost to develop the products or services
• Recruiting and training employees
• Building a customer base

This allows a potential buyer to weigh the value of either setting up a business from scratch, or buying the existing business already set up with customers generating revenue from day one.

Sector Multiples

Some sectors have ‘rules of thumb’ valuation methods, dependent on factors other than profit such as:

• Turnover for a computer maintenance business or a mail-order business
• Number of customers for a mobile phone airtime provider
• Number of outlets for a real estate agency business

A computer maintenance business with 10,000 contracts, but with no profit, may still have considerable value to a buyer looking to acquire the business to take on the customer contracts. The business value may often be an intangible asset, such as its licenses it holds. If it has distribution and licensing rights, or if it is a Registered Training Organization (RTO), the registration has a value.

Management Stability

The fact that the owner and key manager will stay on after settlement has value. This may increase the buy price where the buyer has the comfort and stability to slowly transition the business to its own management style and team. Key relationships with customers also have value. The fact that customers will stay on,  and material agreements in writing, also add value.

Intellectual Property

A business that holds patents, copyrights or trademarks will add value to the purchase price of a business. For example, if you’re selling a patented invention, you can value your business higher than a similar business selling an unprotected product.

Six Valuation Methods

A valuation of a business will give insight into a company’s financial standing, including book value, discounted cash flow analysis, market capitalisation, enterprise value, earnings, and the present value of a growing perpetuity formula.

Book Value

The book value is from the balance sheet. Although simple, it is notably unreliable and is calculated by subtracting the company’s liabilities from its assets to determine owners’ equity. This excludes any intangible assets. Balance sheet figures can’t be equated with value due to historical cost accounting principles and does not give an accurate picture of a business’s true value.

Discounted Cash Flows

Discounted cash flow analysis is the process of estimating the value of a company or investment based on cash flow the business is 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 this method is that it reflects a company’s ability to generate liquid assets. The challenge of this type of valuation is that its accuracy relies on the terminal value, which varies depending on assumptions about future growth and discount rates.

Market Capitalisation

Market capitalisation 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. However, it only accounts for the equity value but 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 paid back with interest over time. Equity represents shareholders who own stock in the company and hold a claim to future profits.

Enterprise Value

The enterprise value is calculated by combining a company’s debt and equity and then subtracting the amount of cash not used to fund business operations. Enterprise Value = Debt + Equity – Cash.

In 2016, Tesla had a market capitalisation of $50.5 billion and 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 capitalisation 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. GM had a market capitalisation 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 capitalisation is higher than both Ford and GM, Tesla is also financed more from equity. 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.

EBITDA

When examining earnings, the tax policies of a country can vary even if nothing actually changes in the company’s operational capabilities. Net income subtracts interest payments to debt holders, which can make organisations look more or less successful based solely on their capital structures. Given these considerations, both are added back to arrive at EBIT (Earnings Before Interest and Taxes), or “operating earnings.”

In normal accounting, if a company purchases equipment or a building, it doesn’t record that transaction all at once. The business charges itself an expense called depreciation over time. Amortisation is the same thing as depreciation but for things like patents and intellectual property. In both instances, no actual money is spent on the expense. In some ways, depreciation and amortisation can make the earnings of a rapidly growing company look worse than a declining one. Brands, like Amazon and Tesla, are more susceptible to this distortion since they own several warehouses and factories that depreciate in value over time.

Tesla had an Enterprise Value to EBITDA ratio of 36x. Ford 15x, and GM’s is 6x.

Present Value of a Growing Perpetuity Formula

One way to think about these ratios is as part of the growing perpetuity equation like a financial instrument that pays out a certain amount of money each year—which grows annually. The growing perpetuity equation enables you to find out today’s value for that sort of financial instrument. The value of a growing perpetuity is calculated by dividing cash flow by the cost of capital minus the growth rate.

Value of a Growing Perpetuity = Cash Flow / (Cost of Capital – Growth Rate)

So, if someone planning to retire wanted to receive $30,000 annually, forever, with a discount rate of 10 percent and an annual growth rate of two percent to cover expected inflation, they would need $375,000—the present value of that arrangement.

What does this have to do with companies? Imagine the EBITDA of a company as a growing perpetuity paid out every year to the organisation’s capital holders. If a company can be thought of as a stream of cash flows that grow annually, and you know the discount rate (which is that company’s cost of capital), you can use this equation to quickly determine the company’s enterprise value.

To do this, you’ll need some algebra to convert your ratios. For example, if you take Tesla with an enterprise to EBITDA ratio of 36x, that means the enterprise value of Tesla is 36 times higher than its EBITDA. If you look at the growing perpetuity formula and use EBITDA as the cash flow and enterprise value as what you’re trying to solve for in this equation, then you know that whatever you’re dividing EBITDA by is going to give you an answer that is 36 times the numerator.

To find the enterprise value to EBITDA ratio, use this formula: enterprise value equals EBITDA divided by one over ratio. Plug in the enterprise value and EBITDA values to solve for the ratio.

Enterprise Value = EBITDA / (1 / Ratio)

In other words, the denominator needs to be one thirty-sixth, or 2.8 percent. If you repeat this example with Ford, you would find a denominator of one-fifteenth, or 6.7 percent. For GM, it would be one-sixth, or 16.7 percent.

Plugging it back into the original equation, the percentage is equal to the cost of capital. You could then imagine that Tesla might have a cost of capital of 20 percent and a growth rate of 17.2 percent.

The ratio doesn’t tell you exactly, but one thing it does highlight is that the market believes Tesla’s future growth rate will be close to its cost of capital. Tesla’s first quarter sales were 69 percent higher than this time last year.

The Power of Growth

In finance, growth is powerful. It explains why a smaller company like Tesla carries a high enterprise value. The market has taken notice that, while Tesla is much smaller today than Ford or GM in total enterprise value and revenues, that may not always be the case.

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