What is Company valuation?
Company valuation is a process and procedures used to establish what a business is worth. It involves checking several aspects like financial health and future prospects. Valuation is important if the company is looking for financing, venture capital, to merge, Acquire, sell or to go for IPO. Company valuation helps measure the progress, by comparing the actual performance and goal set.
How to calculate company valuation?
To get to know the value of a company easily, we can look for the stock price listed in stock exchange. However stocks price alone won't imply the true worth of the company. There are several other parameter to determine the value of a company. We will look at different methods of valuation. Company valuation is no easy task, It requires high financial accounting and mathematical skills, Plus business skills. However with little knowledge we can calculate some basic but very important ratios. In this article, we will look at some valuation formulas as well.
Methods of company valuation
There are several ways in which the company can be valuated, It is important to learn which method suits your business. Now, we will look at three most common company valuation methods.
- Asset Accumulation method: Assets Include fixed assets and current assets. Fixed assets are machines, lands, buildings, intellectual property rights etc. They are valuated after making necessary depreciations and appreciation. Current assets include cash in hand and bank and other cash equivalents like money market, stocks, bonds. It is similar to balance sheet where all assets, liabilities and its value are compiled. This is the most basic method for valuation, The drawbacks with this method is, It does not consider the future earnings of the company, The estimates like depreciation value, appreciation value can be different from what actually is.
- Industry valuation: The company can be valued based on the potential of the industry under which it falls. Here two companies in similar markets are compared. For example, the value of Airtel can be influenced by the JIO company, as they are both from telecommunications industry. Also depending on the future potential of that industry. This method has a downside too because two companies (JIO and Airtel) do not operate in a similar way. So, we must take count of several other factors as well. And this method only works for businesses that can access sufficient market data on their competitors.
- Discounted Cash Flow: One of the main purpose to do company valuation is to know the capacity to earn profits in the future. Discounted Cash Flow (DCF) takes into consideration of expected future earnings of the company and risk the company faces. In this method, we need to project the EBITDA (Earning Before Interest, Taxes, Depreciation, Amortization) for the future years, typically around 5 years. And then calculate the discount rates. Discount rate helps determine present value of the "future" cashflows. DCF is compared with the initial investment. If the DCF is greater than the present cost, the investment is profitable. The higher the DCF, the greater return the investment generates.
Company valuation formula
We will look at some company valuation ratios, which gives a insight about the company.
Price to earnings:
PE RATIO = Current share price/Earnings per share. This gives investor an idea of what the market is willing to pay and its earnings. It is a popular ratio that gives investors a better sense of the value of the company. For example if current share price is 300 rupees and Its previous year's earning per share is 16.5 rupees then, PE ratio = 300/16.5 = 18.18. As the P/E goes up, it shows that current investor sentiment is favorable. A dropping P/E is an indication that the company is out of favor with investors.
Price to sales ratio:
PS Ratio = Current Stock Price / Net Annual Sales of the Company per share. The price-to-sales ratio shows how much the market values every Rupee of the company's sales. The main operation in any business is to generate revenue from the sale of goods and services, and the P/S ratio provides the valuation based on the operations of the company without any accounting adjustments. This ratio is also very useful for companies which have negative or zero net earnings such as start-ups.
The EBITDA-to-sales ratio (EBITDA margin):
This ratio shows how much cash a company generates for each rupee of sales revenue, before accounting for interest, taxes, amortization & depreciation. It is known to focus on the concept of direct operating costs while eliminating the overall effects of the capital structure of the company by getting rid of interest, Income Taxes, amortization & depreciation expenses. We can know the overall profitability of the company by comparing the revenue of the business with its respective earnings. Higher EBITDA margin is a indicator of higher company performance. For example, for a business with its revenues amounting to Rs.3,00,000 and EBITDA of Rs.1,25,000 would have its EBITDA margin at 3,00,000/1,25,000 = 2.4%.