One of the constant elements of business includes continuous monitoring of its profitability. Responding to changing economic conditions is crucial. What is important, such decisions should be based on reliable financial data. So how to determine the value of the company? How to generate gains rather than losses if you need to sell the company? We answer these and more questions in the article below.
Table of Contents
- What is the value of a company and what are its goals?
- Determining the value of a company using the asset-based method
- The income-based valuation method – another way to determine the value of a company
- How to determine the value of a company using the comparative method?
- Methods of determining the value of a company – how to choose the right one?
- How to determine the value of a company? Summary
What is the value of a company and what are its goals?
The value of a company is the difference between the assets indicated in the balance sheet and the market value of its tangible and intangible capital. This is important for investors who intend to acquire the company, but also for its owners. Company value is also relevant for potential legal proceedings and planned tax actions. Therefore, the goal of determining the value of a company is to identify its economic potential. It is crucial to make the most profitable decision about the company’s future. There are three potential methods that allow for valuation of a company:
- asset-based,
- income-based,
- comparative.
Determining the value of a company using the asset-based method
The asset-based method is one of the fundamental ways to determine the value of a company. It involves determining the value of its individual components (assets), and then subtracting the total liabilities associated with running the company, based on data from financial books.
It should be noted that this number should be realistic. It means that it should take into account the change in the value of individual assets owned by the company. In other words, sometimes the value may need to be increased or decreased. The increase can e.g. relate to fluctuations in real estate market prices. Consequently, a decrease may result from the decrease in the value of the company’s assets.
The asset-based method is therefore characterized by the following features:
- focusing on the current value of the company (comparison of assets and liabilities),
- having a simple mechanism – it is enough to analyze the company’s balance sheet,
- not considering all factors influencing the company’s value, such as know-how, experience, qualifications of experts and the customer base.
The income-based valuation method – another way to determine the value of a company
The value of the company in the income-based method is determined through its income. The key in this method is the sum of the values of all monetary transactions that can be used for the payment of profits in a given financial year.
The comparative method allows you to determine a price that is most realistic. This is crucial for negotiations with potential buyers of the company. In addition:
- it demonstrates the company’s ability to generate profits,
- it is complex – valuation using this method requires making many assumptions about the company’s future,
- it requires significant effort and high costs related to preparing financial forecasts,
- it is subject to forecast risk. There is a possibility that assumptions made for valuation will not be confirmed. This can lead to an incorrect assessment of the company’s value.
How to determine the value of a company using the comparative method?
In the comparative method, the mechanism for determining a company’s value is based on comparing entities with a similar business profile. For the credibility of the result, it is crucial that the companies belong to the same market sector or its part. In this method, a similar business profile allows for obtaining similar market-value results.
It should be emphasized that this method can be used by companies whose financial data are public. It’s available for entities whose operating mechanisms (market presence) are transparent. This concerns, for example, entities subject to takeovers or mergers. The choice of the appropriate research group is based on a thorough analysis of economic and financial indicators. They determine the company’s potential compared to others. Such analysis is based on generated income and owned assets.
Finding companies with a high degree of resemblance that allows for a 1:1 comparison is often difficult. Due to the complexity of the data needed for the correct determination of company value using the above method, the Polish Federation of Property Valuers has distinguished the following guidelines for estimating value using the comparative method:
- data on enterprises and prices constituting a comparative basis should be reliable and up-to-date,
- the use of multipliers should be consistent when calculating for all companies,
- due to differences in shareholding in entities, adjustments for control, liquidity and size are necessary,
- extraordinary, non-operational, or one-time events that distort comparability also require adjustments.
Among the characteristics of the comparative method, we can emphasize:
- a simple research assumption,
- a complex mechanism for determining final data,
- focusing on actual market data (income statement, balance sheet, and cash flow statement),
- the dependence of the process on the history of capital transactions in recent years. If it is extensive, the process takes a long time,
- specified guidelines for its application.
Methods of determining the value of a company – how to choose the right one?
When choosing between available methods for determining a company’s value, it is important to note that each method emphasizes different assumptions. Hence, they will show different results. It is common practice to use elements from each method to tailor them to the company’s needs. Thanks to that, one can determine the most reliable value. The market’s specificity and the difficulty of finding two identical companies support this approach. Especially when you consider the comparative method.
Choosing the best method is difficult because it must consider many factors. The economic ones are especially important, as they are independent and objective. Yet, a reliable company valuation is crucial for conducting substantive negotiations during later company-related transactions.
When evaluating a company, it is also important to consider the broad context of accompanying circumstances. Knowing the market situation is also crucial. Bearing this in mind, one must take into account what is the purpose of the valuation:
- continuation of the company’s operations,
- liquidation of business in a non-forced situation – the valued property can be sold without haste.
- liquidation of business in a forced situation – the valued property is to be sold in the shortest possible time, or
- liquidation of unnecessary assets.
How to determine the value of a company? Summary
Determining a company’s value is a complex financial process. It should be based on specific assumptions tailored to the business profile. You must remember that only reliable data about the company will allow you to assess its chances on the market and make the right decision as to its future.
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