The most important valuation methods briefly presented:
The multiple method
To the overview of our current market data on valuation multiples.
Valuation = basic key figure multiplied by the valuation multiple
The multiple method (also known as the “multiplier method”) is a method frequently used in the field of mergers and acquisitions. The method allows a quick check of whether an asking price for the sale of a company is realistic and appropriate on both the buyer and seller side.
This is based on the prices currently achieved by comparable companies that have already been sold. One examines for what multiple (“multiple”, “multiplier”) these companies were sold and applies this factor to the company to be valued. Multiples can, for example, be multiples of operating profit (“EBIT multiple”) or sales (“sales multiple”).
The method is primarily suitable for companies that have been in existence for some time. Here, a multi-year profit trend can be used as a basis for valuation. The better the empirical values, the more meaningful the result will be. In any case, it is advisable to use the multiple method additionally to check the plausibility of the enterprise value.
The 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 for the value of the equity, the financial liabilities must be deducted from the calculated enterprise value.
Valuation using the EBIT multiple method
When valuing the company using the EBIT multiple method, the average net income before interest and taxes (“EBIT”) of the last years is multiplied by the EBIT multiple. Earnings before interest and taxes are taken into account so that the multiples remain comparable even 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 4 – 10 range. A multiple of 6 or higher indicates a high attractiveness of the company. Where within the range the company is located depends on various numerous “soft factors” in addition to the numbers.
NIMBO uses EBITC multiples to calculate company value
This is based on EBIT plus total executive compensation (gross salary, employer contributions to social security, car expenses).
In smaller companies, the managing director can determine his own salary within certain limits. The “EBITC” allows a comparison with the profitability of other companies without distortions due to wages above or below the market wage, peculiarities in capital structures and different tax rates. In the EBIT variant, an adjustment of the CEO wage is also made, 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
Compared to EBIT, EBITDA does not include depreciation and amortization. For the same EBIT, the EBITDA of an asset-intensive company can be significantly higher than that of a personnel-intensive one.
In the case of asset-intensive companies with a high net asset value, it makes sense from a buyer’s point of view to work with EBITDA multiples, as the level of depreciation allows a certain amount of leeway, which can distort the result. The phase of the investment cycle in which the company currently finds itself should also always be taken into consideration. Are there any investments to be made?
Valuation with sales multiples
From an investor’s point of view, the potential profit of a company is of particular interest. However, if the current profit is not meaningful, very small or even negative, another ratio, such as sales, should be considered. This may make sense, for example, if the purchaser believes in improving the return on sales with its own existing, more efficient cost structures. The potential buyer takes a greater risk with this method and must believe that the company will make a profit in the future.
A sales multiple valuation can also be used as a supplement or to check the plausibility of other valuations.
Sales 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. For low-growth and low- or non-profitable companies, sales multiples between 0.2-0.6 are realistic. Depending on the level of sales, a change in the sales multiple by a factor of 0.1 can already have a major impact on goodwill.
If one performs a valuation with both EBIT and sales multiples, and if the valuation with the sales multiple results in a higher value than the valuation with the EBIT multiple, this indicates a lower return on sales than for comparable companies.
Calculation example for the multiple method:
- The example company currently makes 1 million sustainable earnings before interest and taxes (EBIT). “Sustainable” means that it is plausible that this profit can be achieved in the future.
- In the market, it can be observed that small and medium-sized companies are usually sold within the range 4-7 times their EBIT.
- Since the company is in a much better position than the average in many soft factors (e.g. few cluster risks in the customer structure), the company is valued with an EBIT multiple of 6 rather at the upper end of the observed range.
- Goodwill: 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 deducted from the Enterprise Value and results in the sale price for the company’s equity.
- Base selling price = 6 million – 1 million = 5 million.
- At the time of the key date of the sale, the company has temporarily exceptionally high inventories worth 1 million. 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 sales price: 5 Mio + 0. 5 Mio = 5.5 Mio.
The net asset value method
Valuation = net asset value of the company
The net asset value method is the simplest method for determining the value of a company.
One adds the values for fixed and current assets at market prices from the balance sheet, adjusts them for hidden reserves and deducts taxes, debts and liabilities.
What is objectively available is valued, regardless of the interests of the seller or potential buyer.
The big shortcoming of this method is that it completely ignores the future of the company. For example, it does not take into account future revenues, employee knowledge and experience, or established customer and supplier relationships. It also disregards projects that are in the acquisition phase and products that are in the development phase. Projects in the acquisition phase and products in the development phase are also disregarded. The net asset value shows a rather low goodwill.
In connection with the sale of a company, the net asset value has primarily an informational value and is generally below the valuation range of the multiple methods, since no goodwill and earnings potential above the minimum return are represented.
In the event that the net asset value does not yield a return commensurate with the risk or the company even makes a loss, the financial enterprise value – excluding any value-enhancing compound effects with a possible buyer – is basically equal to the liquidation value.
It makes perfect sense to use the net asset value method in combination with other, more optimistic methods, such as the capitalised earnings value method (see section on mean value methods). For industries where fixed assets play an insignificant role and where intangible assets are decisive (such as consulting or software companies), this method is completely unsuitable.
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|
|– accrued liabilities||– EUR 100,000|
|+ Reversal of economically unnecessary provisions||+ EUR 100,000|
|= net asset value||= EUR 500,000|
Significance of the net asset value method
The net asset value method plays only a subordinate role today. The advantages are clearly the simple application and the good traceability of the result. A negative aspect is the low informative value for many companies, as intangible values and future developments are not taken into account.
As a supplementary method, the net asset value method is certainly useful. It quantifies the current value of the company’s existing assets and shows the actual amount of equity. This is of importance for a financing.
The simplified capitalised earnings value method
Valuation = income divided by capitalisation rate
In this method, the company is considered as an investment that yields constant returns. This constant income is valued according to the financial mathematical formula of a perpetual annual income stream. The average expected sustainable after-tax profits over the next three to five years are divided by a risk-adjusted interest rate (“capitalization rate”). The value determined in this way results in the value of the equity (so-called “equity value”).
Since the capitalised earnings value method is based on forecasts, the underlying values should be as realistic as possible. The result should also be checked for sensitivity to changes in assumptions (e.g. lower/higher earnings and interest rates). The question always arises as to what extent the existing earning power of the valued company can be transferred to the buyer in the event of a sale.
Machinery or stocks of goods necessary for normal operations are already included in this calculation, as they are a prerequisite for achieving the sustainable yield on which the valuation is based.
Calculation of the capitalisation rate
Capitalisation rate = base rate plus market risk premium plus company-specific risk premium
The capitalisation rate is made up of three factors.
The base rate, or risk-free rate. It is usually the interest rate on government bonds with a maturity of 10 or thirty years.
The market risk premium, which reflects the entrepreneurial risk in the industry and country concerned.
The company-specific risk premium, which evaluates the specific business risks of the company.
For example, for the valuation of a craft business, an interest rate of around 20 % is usually realistic due to the often higher dependence on the owner. This was empirically proven by real purchase prices.
Factors for determining the risk premium
Fungibility: The company can be turned into money quickly, safely and without high costs. This is generally not the case for unlisted companies.
Role of the company owner: The company is very dependent on the company owner. All decisions and contacts are focused on him.
Company strategy: There is no comprehensible short-, medium- and long-term strategy.
Competition: Compet itive pressure is high, and as a small company with a small market share, there is an increased risk of margin pressure or even being squeezed out of the market.
Customer structure: A large proportion of sales is made with a small number of customers. There are hardly any switching hurdles for customers. The customers have aged along with the owner and will not be around for the foreseeable future.
Supplier structure: There may be supply bottlenecks or delays in production due to dependence on individual suppliers and there are no alternative options.
Management: insufficiently qualified and/or experienced. There is a risk that it will leave the company after a change of ownership.
Employees: The level of education of the employees is rather low. Suitable skilled workers are difficult to find on the labour market, which has a negative impact on future growth. There is a dependence on some key people who are not easily replaced.
Non-recurring revenues: Revenues are primarily generated from non-recurring customers.
Calculation example for the capitalized earnings method:
- sustainable earnings: 1,000,000 (average of the adjusted earnings of the last three years)
- Base interest rate applied: 2% (risk-free interest rate)
- Market risk premium applied: 8% (market premium for the industry)
- risk premium applied to the company: 10% (since it depends to an above-average extent on the owner and the size of the company)
Calculation of the capitalisation rate
- Capitalisation rate = base rate + market risk premium + company-specific risk premium = 2% + 8% + 10% = 20%.
Question from the buyer’s point of view
- As an alternative to buying the firm, how much money would the buyer have to put up in an alternative investment with the same risk to get a return of 1,000,000?
Calculation of capitalised earnings value
- Income value = income / capitalisation rate = 1,000,000 / 20% = 5,000,000
Conclusion / Interpretation
- With a purchase price up to 5,000,000 it makes sense for the buyer to invest the money in the company. With a purchase price above 5,000,000, he could get a better return elsewhere with the money at the same risk.
Significance of the capitalised earnings method in Germany
In Germany, the capitalised earnings method is the most widely used method (IDW S 1). It is the valuation procedure prescribed by law for business valuations for inheritance and gift tax purposes. The capitalised earnings value method is applied accordingly by the tax authorities and finds high acceptance in court disputes.
The discounted cash flow (DCF) method
This method has its origins in classical investment appraisal. Internationally, this is the valuation method with the highest degree of recognition.
Theoretically, the DCF method yields the most accurate enterprise value. The crux, however, is the need to project detailed future earnings or cash flows and the corresponding risk-adjusted interest rates to discount them to their present value.
The advantage over the capitalised earnings value method is the high degree of flexibility, since it is not necessary to assume only one “sustainable earnings”, but it is possible, for example, to forecast the course of the earnings situation separately for each of the next 5 years. However, this also increases the complexity and the need for explanation of the evaluation.
The DCF method is more suitable for determining the 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 capitalized earnings method, which takes future earnings as its starting point, this method looks at cash flows.
A distinction is made between the gross or entity method and the net or equity method. In practice, the majority of companies use the entity method, which is used to determine the enterprise value, i.e. the value of the company including financial liabilities.
The free cash flow of the company, 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. The calculation of the net present value is primarily intended to reflect the operating potential of a company.
As far as possible, an entire investment cycle should be considered, as investments in current and fixed assets have a significant impact on cash flows.
The forecast of cash flows and the choice of discount factors are adjusting screws with which results can be moved in the desired direction. In order to ensure the reliability of the results, a sensitivity analysis showing the impact of changes in the assumptions on the goodwill is essential.
In principle, the choice between the DCF method and the capitalised earnings method has no influence on the valuation result if the premises are the same. The decision in favour of one of the valuation methods should therefore depend on the target group and the purpose of the valuation.
Various averaging methods / mixing methods
Due to the estimation of values, the capitalised earnings value method is associated with uncertainties. The combination methods also include the substance of the company in their valuation.
The idea behind mean value 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. Commercial and craft enterprises and companies from the manufacturing industry use it for planned transactions, but it is also frequently used for family-internal succession arrangements.
The result is based on the weighted average of net asset value and capitalised earnings value. Weighted usually means that twice the income value is added to the net asset value. The result divided by three and increased by the non-operating assets gives the enterprise value. However, alternative methods are also used in which the shares of substance and income in the total value are weighted differently.
The mean value method or Berlin method
In the mean value or Berlin method, the arithmetic mean of the income and asset value is calculated. It is based on the idea that companies with low substance and high earnings are typically exposed to high competitive pressure, which will foreseeably reduce these earnings in the future.
Valuation = (capitalised earnings value + net asset value) / 2
The Vienna procedure
The Vienna method also calculates the arithmetic mean of the income and asset values. However, the calculation of these two values differs, for example, from the Berlin method.
The lump-sum approach to the most difficult factors to determine makes the Vienna procedure a simplified procedure. The capitalization rate is set at nine percent. The uncertain forecast of future earnings is circumvented by taking the average of the last three financial years. The Vienna procedure is often used as an alternative procedure when the parties could not agree on other valuation methods.
Valuation = (capitalised earnings value + net asset value) / 2
The excess profit method
The excess profit method is another mean value method and is based on the assumption that the profit in the long term only corresponds to an appropriate return on net asset value.
As a consequence of the consideration that higher profit margins recede over time, excess profits that exceed the normal rate of return are capitalized at a higher rate of interest. Factors that may be responsible for a decline in profits include a worsening economy, increased competition, or the like.
Two things need to be established for the valuation:
- Amount of the interest rate at which the net asset value earns interest on a sustained basis (“normal interest rate”).
- Number of years for which the excess profit is to apply, which is added to the net asset value.
The interest on the net asset value tied up in the company at replacement prices at the normal interest rate is deducted from the effective profit. This “excess profit” over and above the normal rate of return is added to the net asset value over a certain number of years. As a rule, a period of 3-8 years is used.
= net asset value + present value of excess profits
= net asset value + number of years with excess profit x (profit – (normal interest rate x net 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 business valuation practice.
The Swiss Method or the Practitioner Method
The practitioner method is easy to understand and follow and is often considered the first point of reference on both the buyer and seller side.
For successful companies, the practitioner method results in very conservative, low values for the company.
The Swiss tax administration also uses this valuation method. It assumes a capitalisation rate of 7%.
Valuation = 2/3 x income value + 1/3 net asset value
Special case: valuation of start-ups
The current development phase of the company should always be sufficiently taken into account. Companies in the start-up and growth phase usually generate neither profits nor positive cash flows. This makes an evaluation with the classical methods uncertain. The valuation of startups are therefore a discipline in their own right. The most suitable method is the discounted cash flow method described above, applied to a multi-year business plan. The discount rates used are significantly higher than for established companies and are strongly dependent on the current growth phase.
Special case: low yield with a lot of substance
The Schnettler method deals with the special case of low-income or unprofitable companies with a high net asset value that do not pay an appropriate return on the net asset value. It is my mixed method of asset value and income value.
The depreciation of the high level of property, plant and equipment results in accounting losses. A buyer would carry the property, plant and equipment at reduced replacement cost, reducing depreciation and increasing the capitalized earnings value accordingly.