How much is my company worth? Piotr Łagowski

The necessity to determine the company’s value usually appears when the owner receives the initial sales offer for the company. At that moment, the entrepreneur has to assess whether the terms of the transaction offered are attractive, which inevitably leads to the question “How much is my company worth?” In this article, I would like to discuss the practical aspects of the valuation of an enterprise as part of the process of its sale.

What does the term “company valuation” mean?

An entrepreneur may have come across the concept of valuation of a company or an organised part of it earlier on various other occasions. The valuation of a company or its shares is, for example, a typical action in the course of making changes to the legal structures of companies (transformation into co-partnership, contributions in kind). A variety of valuations is also made when preparing consolidated financial statements to determine the fair value of assets. The valuation can also be an item of collateral provided by the bank. The company’s valuation can even be called simple comparative calculations of the company’s own results in relation to the result and value of listed companies, which can be done by anyone who has some knowledge of the capital market and the stock market. Unfortunately, the usefulness of all these valuations for the professional determination of the company’s value in the sale process is negligible.

This is due to the fact that the value of the company can be estimated in various ways and the basic issue that should always be taken into consideration when selecting the valuation method is its purpose. Having observed the business practice for many years, I can say that the value of a company is estimated completely differently for accounting and tax purposes, in the process of introducing the company’s shares to stock exchange trading, and in the process of acquiring a strategic investor for the company. Therefore, one of the necessary elements of the company’s sales process is to determine the value of the company in terms of the transaction being considered (more about the process itself can be found in the article about selling your own company).

There are numerous methods of estimating the value of a company, but for transaction purposes, essentially three groups of methods are used: the comparative, income-based and asset-based valuation methods.

Comparative methods

Comparative methods are a group of valuation methods in which the financial results or other parameters achieved by the company being valued are compared to similar results generated by comparable companies. Of course, an important element of this valuation is the need to have knowledge about the value of comparable companies, hence the comparison is mainly used by listed companies and those that were recently targeted.

The advantage of this group of methods is primarily the simplicity and reference to the real market valuations of comparable companies. For this reason, these methods are often used when we have limited knowledge about valued companies. These are the basic valuation methods used by stock market analysts and investment advisors. Unfortunately, these methods also have many disadvantages, which result from the low comparability of the financial results of individual companies and the frequent lack of knowledge about specific factors affecting the results and the valuation of comparable companies.

In transactional processes, this method is often used in the initial phases of the project when it is necessary to determine the company value or when there are significant limitations in the access to the source data. These methods are also often used during the further stages of the negotiation process, when the intention of the seller is to show potential investors the “clear” income of the sold company adjusted for one-off factors and taking into account the effects of planned restructuring and future synergies.

Income-based methods

These are a group of valuation methods based on the assumption that a company is worth as much as the present value of the sum of its future income. It is a very logical assumption, but of course, as is easy to guess, the main problem is the necessity of a realistic estimation of future revenues of the valued company. Assumptions for these predictions may be more or less optimistic and you can write whatever you want. In the past, there were many cases of very optimistic forecasts that inflated company valuations, which resulted in great disappointment of stock market investors and, as a result, caused a lot of criticisms towards the income-based methods of company valuation.

In my opinion, the income-based method should be one of the basic valuation methods used in each transaction process. A necessary condition, however, is a cautious approach to the issue of financial forecasts, which cannot be based on the uncritical adoption of the optimistic assumptions contained in the business plans and budgets of the valued companies. It is necessary to understand the sources of income generated by the valued company and knowledge of market trends regarding the profitability of the business. Professional income-based valuation does not have to be detailed and occupy half of the computer’s hard drive. It is important that it is based on realistic assumptions, understandable for the owner.

An income-based valuation prepared in such a way is invaluable in the assessment of offers submitted by investors, because it allows for the comparison of the company’s sales options with the expected effects of selecting other strategic options that the owner of the sold company can choose.

Asset-based methods

This group of methods is based on the assumption that the company’s value is the sum of the value of its assets less the value of its liabilities (in a simplified form, value = realistically valued assets – actual liabilities). In recent years, these methods have lost their importance, and the main reason for this is the lack of credibility of financial statements. Creative accounting, tax optimisation, the increase in the importance of intangible assets, and the development of financial instruments causing off-balance sheet liabilities have led to the situation where, in order to make a reliable valuation of assets, you can rely less on financial statements and more often you have to use the services of specialised appraisers.

In spite of these disadvantages, it is often worth and even necessary to use the asset-based valuation methods, even when determining the structure of transactions (when companies valued have unused assets), as well as a reference point for the evaluation of submitted offers (e.g. by calculating the so-called liquidation value).

Summary

Each of the valuation methods discussed above has its own advantages, but each of them also has serious limitations. In practice, therefore, mixed valuations are used, which constitute a weighted average valuation obtained from the use of various methods. The selection of appropriate methods and appropriate valuation tools for each individual case is one of the key elements of success.

A characteristic feature of any valuation performed for transaction purposes should be a practical approach and focus on answering the 2 main questions:

• what kind of offers an entrepreneur considering the sale of his company can expect?
• how attractive are the offers made by the investors in relation to other strategical options?

In order to be able to answer these questions effectively, the valuation expert should have full access to all relevant data about the company being valued. You cannot expect complete answers from an expert who has access only to financial statements and who does not have any relevant information explaining those reports. Close cooperation between the board of the company being valued and this expert is also necessary to prepare realistic financial forecasts together. For this reason, I think that from the entrepreneur’s point of view, the best results are achieved by working with the same transaction advisor who understands the business you run and which you can fully trust.

Links

For those who have read my article and want to deepen their knowledge about the subject of the valuation of the enterprise, I recommend first reading the note of the Polish Federation of Valuers’ Associations, which is a set of principles of good professional practice in this topic- Note No. 5.