What’s your company worth? It’s an important question that has confounded the best investors and academicians. Much like any other complex mathematical problem, the value of a company depends on a number of factors, including its earnings.
If you’re a business owner, understanding the value of your business becomes more important as your business grows. The need for business valuation can arise due to various reasons, including a business sale, inheritance, lawsuits, public offering, etc.
If you’re an investor, you want to get accurate figures for your potential return on investment. With such an important subject, guesswork simply won’t cut it. So how is a company value calculated? In this post, we’ll explain the various approaches you can use to calculate the value of public and private companies.
The most reliable and straightforward way to determine the value of a company is to calculate its market capitalization.
Market capitalization, commonly called market cap, is obtained by calculating the total number of outstanding shares with the current share price. It’s a measure of a corporation’s total value in the stock market.
Company value = Total number of outstanding shares x price per share (PPS)
For example, let’s say Microsoft’s price per share (PPS) is $145 and the total number of outstanding shares is 3.2 billion. In this case, if you multiply the PPS by the number of outstanding shares (145 x 3.2), Microsoft is worth $464 billion.
Note that the market capitalization method only works for publicly traded companies, where the share values can easily be determined.
This approach involves using a multiple of the company’s earnings or the price-to-earnings ratio to get an accurate figure of a company’s value.
So how does it work?
You calculate estimates of your company’s earnings for the next few years (at least 3 years). Once you have the figures, find out what the typical price-to-earnings (P/E) ratio is in your industry and multiply it with the projected estimate figure.
For example, if your P/E is 15 and your projected earnings per year are $150,000, your company’s value would be $2.25 million. For more information on this, ClearLight Partners have a very insightful article on how to value a private company based on earnings that you should check out.
The market approach determines the value of a company based on the purchases and sales of comparable companies within the same industry.
To calculate a company’s value using this method, you take the stock price of a similar company in the same industry and multiply by the number of shares the company has.
For example, a beverage company is similar to other beverage companies on the stock market valued at $15 and $20 per share, with each company having 20,000 shares. Multiplying the price per share with the outstanding number of shares, we get two different market values. That is $300,000 (15 x 20,000) and $400,000 (20 x 20,000).
So your company is valued between $300,000 and $400,000. This method is ideal as long as you can get sufficient data on which to compare with your business.
This approach seeks to calculate the present value of future cash flows of a company. Discounting to present value is done using the company’s cost of capital.
This method employs a complex formula that project’s a business annual cash flow into the future and then calculates the value of future cash flows to today, using a net present value (NPV) formula. You can easily calculate this value using an NPV calculator.
What other techniques do you use to value a company? Share with us in the comments section below.