Investing is not an exact science. Despite many assigning a fixed value to an investment after a lengthy analysis, businesses cannot be summed up in just one number. While calculating a company’s earnings, book value, and cash flow is very useful; it is only part of the whole valuation process. There are many subjective interpretations of a business, such as quality of management, the value of intangible assets, and predictability. Companies change over time, and the further out the prediction, the less accurate the forecast.
The most common way to value a business is by calculating its Net present value (NPV). NPV is used to discount the value of all estimated future cash flows of a business, and therefore its current value. Other common methods are liquidation value, book value, and earnings.
Business valuation methods
Despite the part-subjective nature of business valuation, investors must start with a calculation of the company’s value. Businesses are at a bargain when trading below their underlying value, and it is the investor’s task to discover these bargains. The two most useful methods are NPV and liquidation value.
Net Present Value method of business valuation
NPV is the discounted (i.e., the interest rate used in the calculation) value of all future cash flows that a company is predicted to make. As mentioned, as a bond’s future cash flow is known, its value can be precisely calculated, along with an appropriate discount rate, using NPV. However, this is not the case with businesses. Cash flows are estimates and what discount rate is used is often subjective. Companies are under constant pressure from competition, industry-wide problems, and macro-economic issues. Small changes in revenue, expenses, inflation, or interest rates can significantly change cash flows. Management can help mitigate some of these issues, but no business is immune to challenges. This makes using NPV to value a business difficult.
Some companies’ future cash flows are more certain than others; for example, the likelihood that Apple will be selling more iPhones ten years from now is more certain than a new pharmaceutical company relying on FDA approval for its success. This uncertainty is why a margin is crucial to protect investors’ downside. By purchasing at a discount, the investor can protect themselves from error.
What discount rate to apply to Net Present Value?
As part of the NPV calculation, investors must include a discount rate. The rate depends on the individual’s risk tolerance and time horizon. For example, some conservative investors with a long-term horizon view may apply a high discount rate (creating a higher investment barrier). In contrast, others may have a more optimistic outlook and use a lower discount rate. There is no single correct rate to calculate NPV.
A common figure is the US 10-year Treasury rate, the amount an investor can receive “risk-free.” But even these rates can often be relatively low and need adjusting upwards. When interest rates are low, it is typical for the PE ratios of companies to be elevated. However, the high PE ratio often depends on interest rates remaining low, and no one can predict with certainty where interest rates are heading. The NPV method is most suitable for valuing a high-return business with steady cash flows.
Liquidation value method for business valuation
The liquidation value method is determined by calculating the remaining value of a company if all assets were sold and all debts repaid. This is a very conservative way of valuation as intangible assets are not included, and a company’s brand can be one of its valuable assets. This method is most useful in the Benjamin Graham approach to finding businesses selling at a deep discount to liquidation value. It is one of the surest ways investors can be confident they are receiving more value than what they are paying. The assets are calculated as follows: tangible assets are usually assessed at book value, securities are valued at market price, accounts receivable are at their face amount, finished goods are based on the salability, and cash is valued at 100 percent.
An even more conservative method, popularized by Benjamin Graham, is “net-net working capital,” where working capital (current assets minus current liabilities) is subtracted from long-term liabilities. If a company is purchased at below net-net working capital, investors are protected by the liquidation value of current assets alone. The liquidation value method is most appropriate for struggling companies trading below book value.
Common business valuation metrics
Earnings-per-share (EPS) is a standard metric used by investors to get a one-shot look at how profitable a company is. However, EPS can be imprecise and manipulated through accounting, especially when managers know how essential earnings are to investors. It also does gives little indication of what the future earnings of a company may be. EPS also does not tell the investor the cash flow of a business, which is what the business is left with after expenses.
Book value is another standard method of quick valuation of a business. However, it is also not without flaws. Book value is a historical look at what a business is worth, not its value today. For example, if a company has a high inventory of perishable goods, their value is not held for an extended period. Furthermore, technological advancement can cause equipment to be obsolete, and regulation can devalue certain assets. Until the equipment is sold, there is no way of truly knowing its worth.
What is the range of business valuation?
Unlike bonds, companies do not have scheduled exact amounts of cash flows. A bond’s value is directly related to the present value of all the cash flows. This includes the annual coupon payment and the face value of the bond. Whereas a business’s cash flows can only be estimated. Because of this impreciseness, a wide margin of safety is needed when investing in a company. I.e., you may estimate a company to be worth double its asking price, and it doesn’t matter if you are off by 10 or 20 percent; you know it is a great bargain.
A business’s value can be hidden
It is extremely difficult to calculate a company’s intangible assets. There is no way of truly knowing the value of a brand or intellectual property of a business, and its real value is often hidden from the investors. For example, many did not spot the opportunity in Amazon before it became the giant it is today. Amazon famously reported little to no profits all while continuing to build a loyal base of returning customers. This loyalty does not show up in financial statements. Growing sales and cash flows give an investor some indication of the increase in a company’s value.
