In situations involving the breakup, merger, or sale of a company, for tax purposes and to court investors, a valuation process may be necessary. If a company does not have one, it may have to develop one.
Valuation is the appraisal of an enterprise. It is the process of estimating how much an enterprise is worth, which involves identifying its fair price and ROI. This process of estimating value is systematized through the use of a quantitative model.
There are several approaches to this process, the most common being computing the value of equity, the present value of the future cash flow (i.e., discounted cash flow), and the value of enterprise multiples.
The calculation involves estimating near-term EBITDA (earnings before interest, taxes, depreciation, and amortization), as well as investments, working capital cycle, and taxes on earnings.
With operation values calculated, financial liabilities and tax and labor contingencies are discounted, and financial investments are added, for example. One arrives at the market value of the company, also called equity value.
As we have seen, many variables will be analyzed simultaneously, and the entrepreneur can clearly see which ones help increase or decrease the value of the business.
As mentioned above, three methods are most used to estimate the enterprise value: discounted cash flow, multiples valuation, and equity value. These can be seen in Figure 1.
In a discounted cash flow (DCF) analysis, the company’s ability to generate wealth in the future is analyzed over a minimum horizon of five years. The greater the growth potential, the greater the value of the company. Fixed assets and company history are just starting points, since prospects for future performance are most important.
Among the variables that help to compute enterprise value by DCF, the most important is its ability to generate cash, EBITDA. The cash flow method is generally calculated in three steps: Initially, cash flow (receivables minus expenditures) is calculated for the next periods; then the discount rate is defined, based on the risk of other investment opportunities (e.g., the risk-free rate of T-Notes); finally, the present value is calculated.
This figure is the basis for estimating company growth. But in order to reach a final value, one must consider other variables, such as customer portfolio, distribution network, and quality of business management. In no other methodology are the details of the operation as relevant to the final result as in DCF.
In the multiples valuation method, enterprise value is established through comparisons with similar companies, usually listed on the stock exchange. In order to carry out the comparison, the companies must be from the same sector, have a similar product / service portfolio, and target the same customer profile. In the case of publicly listed companies that have a known market value, simply multiply share price by the total number of outstanding shares.
Finally, in the equity value method, book value is the sum of all assets, such as buildings, machinery, equipment, cash and inventory, less debts and financial obligations. The equity method is often used for negotiations between partners, in light of the possible exit of one of them.