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Determining the fair market value of a company can be a complex task. There are many factors to consider, but it's an important financial skill businesses leaders need to succeed. So, how do finance professionals evaluate assets to identify one number?
Below is an exploration of some common financial terms and methods used to value businesses, and why some companies might be valued highly, despite being relatively small.
Company valuation, also known as business valuation, is the process of assessing the total economic value of a business and its assets. During this process, all aspects of a business are evaluated to determine the current worth of an organization or department. The valuation process takes place for a variety of reasons, such as determining sale value and tax reporting.
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One way to calculate a business’s valuation is to subtract liabilities from assets. However, this simple method doesn’t always provide the full picture of a company’s value. This is why several other methods exist.
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.
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. Then exclude any intangible assets. The figure 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. Relying on basic accounting metrics doesn't paint an accurate picture of a business’s true value.
Another method of valuing a company is with discounted cash flows. This technique is highlighted in the 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 liquid assets. 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.
Market capitalization is one of the simplest measures of a publicly traded company's value. It’s calculated by multiplying the total number of shares by the current share price.
Market Capitalization = Share Price x Total Number of Shares
One 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.
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
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.
When examining earnings, financial analysts don't like to look at the raw net income profitability of a company. It’s often manipulated in a lot of ways by the conventions of accounting, and some can even distort the true picture.
To start with, the tax policies of a country seem like a distraction from the actual success of a company. They can vary across countries or time, even if nothing actually changes in the company’s operational capabilities. Second, net income subtracts interest payments to debt holders, which can make organizations 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 instead charges itself an expense called depreciation over time. Amortization 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 amortization can make the earnings of a rapidly growing company look worse than a declining one. Behemoth brands, like Amazon and Tesla, are more susceptible to this distortion since they own several warehouses and factories that depreciate in value over time.
With an understanding of how to arrive at EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) for each company, it’s easier to explore ratios.
According to the Capital IQ database, Tesla had an Enterprise Value to EBITDA ratio of 36x. Ford's is 15x, and GM's is 6x. But what do these ratios mean?
One way to think about these ratios is as part of the growing perpetuity equation. A growing perpetuity is a kind of financial instrument that pays out a certain amount of money each year—which also grows annually. Imagine a stipend for retirement that needs to grow every year to match inflation. 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 organization’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.
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.
If you want to advance your understanding of financial concepts like company valuation, explore our six-week online course Leading with Finance and other finance and accounting courses to discover how you can develop the intuition to make better financial decisions.
This post was updated on April 22, 2022. It was originally published on April 21, 2017.
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