COMPANY VALUATION METHODS
Here you will find the most important methods for the company valuation of SMEs explained in a comprehensible way.
The four most important methods for calculating the company value for small and medium-sized companies are the multiple method, the net asset value method, the earnings value method and the DCF method. Here’s what you should know about each method. Simply explained and with examples.
Related topics : Use our current online company valuation for a valuation using the multiple method, based on current multiples and individual value drivers. In addition, we publish the current valuation multiples for many countries, sectors and company sizes every month. You can find more detailed information on the sale of a company and the topic of company valuation in the guide on the topic of company sales and in the general guide on the topic of company valuation .
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THE MOST IMPORTANT VALUATION METHODS IN BRIEF:
Multiple method
Orientation towards purchase prices achieved for similar companies
Net Worth Method
Market values of the objectively existing tangible assets in the company
Simplified Earnings Value Method
The company as an investment that generates a certain interest rate
DCF procedure
Future cash flows are discounted at an appropriate rate
The multiple method
For an overview of our current market data on valuation multiples .
Rating = Base metric multiplied by the rating multiple
The multiple method (also «multiplier method») is a procedure that is often used in the area of mergers and acquisitions. The method enables a quick check to be made as to whether the expected purchase price for a company sale is realistic and appropriate for both the buyer and the seller.
The prices currently achieved by comparable companies that have already been sold are used. One examines the multiple (“multiple”, “multiplier”) for which these companies were sold and applies this factor to the company to be valued. Multiples can be, for example, multiples of operating profit (“EBIT multiple”), earnings before interest, taxes, depreciation and amortization (EBITDA multiple) or sales (“sales multiple”).
The method is primarily suitable for long-established companies. Here, a profit development over several years can be used as a basis for evaluation. The better the empirical values, the more meaningful the result will be. In any case, it is advisable to use the multiple method in addition to the plausibility check of a company value that has resulted from another method.
The indicative value of the company determined with the multiple corresponds to the “enterprise value”. This is the value of equity plus financial debt. This means that the financial debt must be deducted from the determined company value for the value of the equity.
Valuation using the EBIT multiple method
When evaluating the company using the EBIT multiple method, the average net earnings before interest and taxes (“EBIT”, earnings before profit and taxes) of the last few years are multiplied by the EBIT multiple. The earnings before taxes and interest are considered so that the multiples remain comparable for companies with different tax rates and debt capital structures. For smaller companies with sales of up to 20 million, the observed range for multiples is mainly in the range of 4 – 10. A multiple of 6 or higher means that the company is highly attractive. Where the company is within the range depends on the numbers and on various numerous “soft factors”.
NIMBO uses EBITC multiples for company valuation
Here, the EBIT plus the entire management compensation (gross salary, employer’s contribution to social security, car expenses) is taken as the basis.
In smaller companies, the managing director can determine his own wages to a certain extent. The “EBITC” allows a comparison with the earning power of other companies without distortions due to wages that are above or below the market wage, peculiarities in the capital structures and different tax rates. With the EBIT variant, the manager’s salary is also adjusted, but NIMBO prefers the EBITC variant because, from an empirical point of view, it can explain observed purchase offers better than the EBIT variant.
Valuation using the EBITDA multiple method
Unlike EBIT, EBITDA (earnings before interest, taxes, depreciation and amortization) does not include depreciation and amortization. With the same EBIT, the EBITDA of a capital-intensive company can be significantly higher than that of a personnel-intensive one.
In the case of capital-intensive companies with a high intrinsic value, it makes sense from the buyer’s perspective to work with EBITDA multiples, since the level of depreciation allows a certain amount of leeway, which can distort the result. It should always be considered which phase of the investment cycle the company is currently in. Investments coming up?
Rating with sales multiples
From an investor’s point of view, the possible profit of a company is of particular interest. However, if the current profit is not meaningful, very small or even negative, another metric, such as sales, should be looked at. This can make sense, for example, if the buyer believes in improving the return on sales with his own existing, more efficient cost structures. The potential buyer takes a greater risk with this method and has to believe that the company will make profits in the future.
A sales multiple evaluation can also be used as a supplement or to check the plausibility of other evaluations.
Revenue multiples are significantly smaller than EBIT multiples. The observed range is mostly between 0.2 and 2, depending on the industry, profitability, growth prospects and some other factors. Sales multiples of between 0.2-0.6 are realistic for low-growth and little or no profitable companies. Depending on the amount of sales, even a change in the sales multiple by a factor of 0.1 can have a major impact on the value of the company.
If you carry out an evaluation with both EBIT and sales multiples, and if the evaluation with the sales multiple results in a higher value than the evaluation with the EBIT multiple, this indicates a lower return on sales than in comparable companies.
Calculation example for the multiple method:
- The example company is currently making 1 million sustainable earnings before interest and taxes (EBIT). “Sustainable” means that it is plausible that this profit can also be achieved in the future.
- It can be observed on the market that small and medium-sized companies are mostly sold within the range of 4-7 times their EBIT.
- Since the company is in a better position than the average in many “soft factors” (e.g. few cluster risks in the customer structure), the company is rated with an EBIT multiple of 6 at the upper end of the observed range.
- Enterprise value: 1 million x 6 = 6 million (this is the so-called “enterprise value”)
- Derivation of the sales price (“equity value”) from the enterprise value: The company has a bank loan of 1 million, which is taken over by the buyer. This is subtracted from the Enterprise Value and gives the selling price for the company’s capital.
- Base Selling Price = 6M – 1M = 5M
- At the time of the sale, the company temporarily had exceptionally high inventories worth 1 million. The usual average is 500,000. Since the inventories can be sold with a high degree of certainty in this case, 500,000 is added to the sales price (so-called closing balance sheet adjustment).
- Final sale price: 5M + 0.5M = 5.5M
The substance value method
Valuation = intrinsic value of the company
This is the simplest method of determining intrinsic value.
You add the values for the fixed and current assets at market prices from the balance sheet, correct them for the hidden reserves and deduct the taxes, debts and liabilities.
What is objectively there is valued, regardless of the interests of the seller or potential buyer.
The major shortcoming of this method is that it completely ignores the future of the company. For example, it does not take into account future income, the knowledge and experience of employees, or established customer and supplier relationships. Projects that are in the acquisition phase and products that are in the development phase are also ignored. The net asset value shows a rather low company value.
In connection with the sale of a company, the intrinsic value primarily has an informational value and is usually below the valuation range of the multiple methods, since no goodwill and earnings potential above the minimum interest rate are shown.
In the event that the net asset value does not receive risk-adequate interest or the company even makes a loss, the financial company value – without any value-enhancing group effects with a possible buyer – is basically the same as the liquidation value.
It makes sense to use the net asset value method in combination with other, more optimistic methods, such as the earned value method (see the section on averaging methods) . This method is completely unsuitable for industries in which fixed assets play an insignificant role and in which intangible assets are decisive (such as consulting or software companies).
Calculation example for the net asset value method:
| Value of fixed and current assets (at market prices) | EUR 1,000,000 |
|---|---|
| – Liabilities/Debts | – EUR 500,000 |
| – Accruals | – EUR 100,000 |
| + Release of economically unnecessary provisions | + EUR 100,000 |
| = intrinsic value | = EUR 500,000 |
Importance of the net asset value method
The net asset value method only plays a subordinate role today. The advantages are clearly the simple application and the good traceability of the result. The low informative value for many companies is negative, since intangible values and future development are not taken into account.
The asset value method makes perfect sense as a supplementary method. It quantifies the fair value of the company’s existing assets and shows the actual amount of equity. This is important for financing.
simplified earnings method
Valuation = income divided by capitalization rate
When valuing a company using the discounted earnings method, the company is viewed as an investment that yields constant returns. These constant returns are valued according to the mathematical formula of a perpetual annual stream of income. The average expected sustainable after-tax profits over the next three to five years are divided by a risk-adjusted interest rate (“cap rate”). The value determined in this way results in the value of the equity (so-called “equity value”).
Since the discounted earnings method is based on forecasts, the underlying values should be as realistic as possible. The result should also be checked for its sensitivity to changed assumptions (e.g. lower/higher income and interest rate). The question always arises to what extent the existing earning power of the rated company can be transferred to the buyer in the event of a sale.
Machines or stocks of goods that are necessary for normal operations are already included in this calculation, as these are prerequisites for achieving the sustainable income on which the valuation is based.
Calculation of capitalization interest
Capitalization interest rate = base interest rate plus market risk premium plus company-specific risk premium
The capitalization rate consists of three factors.
The base interest rate, also known as the risk-free interest rate. It is usually the interest rate on government bonds with a maturity of 10 or 30 years. At the end of 2021, the basic interest rate in Germany was around 0.10%.
The market risk premium, which reflects the entrepreneurial risk in the relevant industry and country.
The company-specific risk premium, which evaluates the company’s specific business risks.
For example, an interest rate of around 20% is usually realistic for the valuation of a craft business due to the often higher dependence on the owner. This has been empirically proven by real purchase prices.
Factors used to determine the risk premium
Fungibility : The company can be monetized quickly, safely and without high costs. This is usually not the case with non-listed companies.
Role of the business owner: The company is very dependent on the business owner. All decisions and contacts are focused on him.
Company strategy: There is no comprehensible short, medium and long-term strategy.
Competition: Competitive pressure is high and as a small company with a small market share there is an increased risk of pressure on margins or even being forced out of the market.
Customer structure: A large part of the turnover is made with just a few customers. There are hardly any switching hurdles for customers. The customers have aged with the owner and will be gone for the foreseeable future.
Supplier structure: Dependence on individual suppliers can lead to delivery bottlenecks or delays in production and there are no alternatives.
Management: It is insufficiently qualified and/or experienced. There is a risk that it will leave the company after a change of ownership.
Employees: The level of training of the employees is rather low. Appropriate skilled workers are difficult to find on the labor market, which has a negative impact on future growth. There is a dependency on a few key people who are not easy to replace.
One-time sales: Sales are mainly generated with non-recurring customers.
Calculation example for the earning power method:
initial position
- Sustainable Yield: 1,000,000 (average of adjusted earnings over the last three years)
- Base interest rate applied: 2% (risk-free interest rate)
- applied market risk premium: 8% (market premium for the industry)
- Company-specific risk premium: 10% (since it is above average and depends on the owner and the size of the company)
Calculation of capitalization interest
- Capitalization rate = base interest rate + market risk premium + entrepreneur-specific risk premium = 2% + 8% + 10% = 20%
Question from the buyer’s point of view
- As an alternative to buying a company, how much money would the buyer have to invest in an alternative investment with the same risk in order to achieve a return of 1,000,000?
Calculation of Earned Value
- Income value = income / capitalization rate = 1,000,000 / 20% = 5,000,000
Conclusion / interpretation
- With a purchase price of up to 5,000,000, it makes sense for the buyer to invest the money in the company. With a purchase price of more than 5,000,000, he could earn a better return elsewhere with the money at the same risk.
Importance of the discounted earnings method in Germany
In Germany, the discounted earnings method is the most widespread method (IDW S 1). It is the valuation procedure prescribed by law for company valuations for inheritance and gift tax. The discounted earnings method is used accordingly by the tax authorities and is widely accepted in court disputes.
For the evaluation of small and medium-sized craft businesses, the working group of value-determining business consultants in the craft industry has developed the AWH standard. It is also based on the discounted earnings method and is adapted accordingly to the special features of these companies. Further information is available from the ZdH on evaluation according to the AWH standard.
The discounted cash flow method (DCF)
This method has its origins in classic investment calculations. Internationally, this is the assessment method with the highest level of awareness.
Theoretically, the DCF method gives the most precise company value. The crux of the matter, however, lies in the need to project detailed future earnings or cash flows and the corresponding risk-adjusted interest rates (impact rate) to discount them to their present value.
The advantage over the earnings value method is the high level of flexibility, since not only one single “sustainable yield” has to be assumed, but rather the development of the earnings situation can be forecast separately for the next 5 years, for example. However, this also increases the complexity and the need for explanation of the evaluation.
The DCF method is more suitable for determining the company value of large companies. The starting point is always a business plan for the next 5-7 years. This method tends to result in higher company values.
In contrast to the discounted earnings method, which uses future earnings as a starting point, the surplus payments, so-called cash flows, are considered here.
A distinction is made between the gross or entity method and the net or equity method. In practice, the entity method is mostly used, with which the enterprise value, ie the company value including financial liabilities, is determined.
Here, the company’s free cash flow, including interest on borrowed capital, is discounted to the present day using the weighted average cost of capital of the financial resources tied up in the company. With the calculation of the net present value, the operational potential of a company should primarily be shown.
As far as possible, an entire investment cycle should be considered, since investments in current and fixed assets have a significant impact on cash flows.
The forecast of cash flows and the choice of discounting factors are parameters that can be used to move results in the desired direction. In order to ensure that the results are reliable, a sensitivity analysis that shows the influence of changes in assumptions on the company value is essential.
In principle, the choice between the DCF method and the discounted earnings method has no effect on the result of the valuation if the premises are the same. The decision for one of the evaluation methods should therefore be made dependent on the target group and the purpose of the evaluation.
Various averaging methods / mixing methods
Due to the estimation of the values, the discounted earnings method is associated with uncertainties. The combination methods also include the substance of the company in their assessment.
The idea behind averaging methods is to include both past and future expectations and risks. This leads to a high level of acceptance, also and especially among companies in the SME sector. Trade and craft companies and companies from the manufacturing sector use them for planned transactions, but they are also often used for family-internal succession planning.
The result is based on the weighted average of asset value and earnings value. Weighted usually means that twice the earnings value is added to the net asset value. The result divided by three and multiplied by the non-operating assets gives the enterprise value. However, alternative methods are also used, in which the proportions of substance and income in the total value are weighted differently.
The mean value method or Berlin method
With the mean value or Berlin method, the arithmetic mean is formed from the earnings value and the net asset value. It is based on the idea that high-yield, low-funded companies are typically exposed to high levels of competitive pressure that will likely reduce those earnings in the future.
Valuation = (Earnings Value + Net Asset Value) / 2
The Vienna process
The Vienna method also calculates the arithmetic mean of the earnings value and the net asset value (asset value). However, the calculation of these two values differs from the Berlin method, for example.
The generalization of the factors that are most difficult to determine makes the Vienna procedure a simplified procedure. The capitalization interest rate is fixed at nine percent. The uncertain forecast of future earnings is circumvented by taking the average of the last three financial years. The Vienna method is often used as an alternative method if the parties could not agree on other valuation methods.
Valuation = (Earnings Value + Net Asset Value) / 2
The Surplus Method
The excess profit method is another averaging method and is based on the assumption that the profit in the long run only corresponds to a reasonable return on the asset value.
As a result of the belief that higher profit margins will recede over time, excess profits in excess of normal interest are capitalized at a higher interest rate. Factors that can be responsible for a decline in profits are, for example, a poorer economy, increased competition, etc.
Two things must be determined for the valuation:
- Amount of the interest rate, with which the net asset value earns long-term interest (“normal interest rate”).
- Number of years for which to apply the excess profit that is added to the net asset value.
The interest on the intrinsic value tied up in the company at replacement prices at normal interest is deducted from the effective profit. This “surplus profit” in excess of the normal interest rate is added to the net asset value over a certain number of years. Usually a period of 3-8 years is used.
VALUATION
= intrinsic value + cash value of excess profits
= asset value + number of years with excess profit x (profit – (normal interest rate x asset value))
Numerical example: 1,000,000 + 3 x (200,000 – (10% x 1,000,000)) = 1,300,000
Significance of the excess profit method: It plays no role in company valuation practice.
The Swiss method or the Praktiker method
The practitioner method is easy to understand and understand and is often used as the first point of reference for both the buyer and seller.
In the case of successful companies, the practical method leads to very conservative, low values for the company.
The Swiss tax authorities also use this valuation method. It expects a capitalization rate of 9.5%.
Valuation = 2/3 x earned value + 1/3 intrinsic value
The Stuttgart process
With the Stuttgart method, the value of a company results from the sum of the net asset value and the earnings value. This method was primarily used to determine the business value of unlisted companies in the event of inheritance or gifts. Since this procedure is no longer up-to-date, it was abolished in 2009.
special cases
Special case: startup valuation
Special case: low-yield with a lot of substance
The Schnettler method deals with the special case of low-yield or unprofitable companies with a high intrinsic value that do not pay appropriate interest on the substance. It’s my mix of intrinsic value and earnings value.
Accounting losses are incurred as a result of the depreciation on the high level of property, plant and equipment. A buyer would account for the property, plant and equipment at reduced replacement cost, which reduces depreciation and increases earnings accordingly.
frequently asked questions
What is the best method of company valuation?
Depending on the reason for the assessment and the phase the company is in, one or the other method may make more sense. We recommend trying out several methods to get a feel for the range within which the value moves. Nimbo works with the multiple method.
How does the multiple method work?
This method requires recent prices from comparable companies as a basis for calculation. One examines the multiple (“multiple”, “multiplier”) for which these companies were sold and applies this factor to the company to be valued. Multiples can be, for example, multiples of operating profit (“EBIT multiple”), earnings before interest, taxes, depreciation and amortization (EBITDA multiple) or sales (“sales multiple”).
What method is used to evaluate a start-up?
With a start-up that is not yet turning a profit and is growing strongly, you evaluate a promise for the future. The DCF method can be applied to start-up business plans. The discount rate used is derived from the investors’ expected return.
For whom is the multiple method (multiplier method) suitable?
This method is primarily suitable for long-established, profitable companies. Here, a profit development over several years can be used as a basis for evaluation. The more stable the empirical values, the more meaningful the result. This method is not suitable for companies that are making losses or are in a strong growth phase.
