There are various methods for valuing businesses, some of which are presented here. It is important to know that many methods used in practice are not suitable for determining the business value.
If you want to understand the principle with an example, read the explanations on the capitalised earnings method.
Call NowThe business value results from the benefit of the future cash flow to the owners. The future cash flow is discounted to the present date, taking into account personal circumstances such as alternative investments and tax rates. In addition to this (correct) subjective determination of the business value, an objectified business value is often also determined, which is based on the assumptions of a perfect capital market. However, a perfect capital market does not exist in reality. There are also some dubious valuation methods.
In the case of business valuation methods based on the present value calculation (discounting), a distinction can be made between entity and equity approaches. Entity approaches are often based on the equilibrium theory of Modigliani and Miller (1958) and partly on the Capital Asset Pricing Model (CAPM) (Sharpe, 1964; Lintner, 1965; Mossin, 1966). The basic idea is that there is a total enterprise value, which consists of the value of equity and the value of debt. The following is a list of business valuation methods.
The APV approach can be traced back to Myers (1974) and is an entity method for business valuation. The enterprise value consists of three parts: the base present value of the unlevered company, the value of debt capital, and the value of the tax shield. The tax shield represents the advantage that arises from the tax benefits of borrowed capital. Each of these values is determined by discounting, whereby the base present value is discounted at the cost of equity of the unlevered company, and the other two are discounted at the cost of debt.
If the value of the debt capital is deducted from the sum of the base present value and the tax shield, the value of the equity capital is obtained.
Detailed information and an example of the APV approach can be found here.
The WACC approach is an entity method for business valuation. The equity-financed cash flow is discounted using WACC. WACC is an interest rate weighted by the value of equity, debt, and the tax shield. The calculated enterprise value is corrected by the value of the debt, as it is an entity approach. For a proper calculation, the data from the APV approach must actually be used.
Detailed information and an example of the WACC approach can be found here.
In functional valuation theory, the business value is calculated using linear or non-linear optimisation. All cash flows and withdrawal preferences are modelled. This can be thought of as a kind of complete financing plan that takes all interdependencies into account. The relevant interest rates (endogenous marginal interest rates) can be calculated retrospectively from the so-called dual variables.
In the original capitalised earnings method or, in the language of IDW S 1, the subjective capitalised earnings method, the cash flow to the owners is discounted using a subjective discount rate, taking into account personal alternative investments and taxes. In this case, the capitalised earnings method is based on the same theoretical principles as the functional valuation theory, except that the discount rate is estimated.
In the objectified capitalised earnings method according to IDW S 1, it is merely an alias for the equity approach.
You can find more information on the capitalised earnings method here.
The equity approach is an equity method of business valuation. The cash flow to the owners is discounted at the cost of equity (of the leveraged company).
Detailed information and an example of the equity approach can be found here.
Multipliers (also called multiples) are methods of business valuation which are not permitted by the Institute of Public Auditors in Germany (IDW S 1) for determining the business value. There are, among others, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortisation (EBITDA), and revenue multipliers. These should never be used as a basis for decisions.
The net asset value method is a dubious method of business valuation. In IDW S 1 of the Institute of Public Auditors in Germany, its application is prohibited unless explicitly commissioned. (The liquidation value in the event of a company being discontinued is also a future success method, which is based on the current point in time. The liquidation value is considered when the company is being discontinued.)
For a theoretically sound business valuation, only the functional valuation theory and the original capitalised earnings method or subjective capitalised earnings method in accordance with IDW S 1 can be considered.