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| Published in: Succeed in money
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Valuation is a complex process that requires the input from specialist advisors, but business owners can use certain techniques to form a pre-existing idea of the company’s worth before doing a full valuation.
The first point to consider is fair market value versus investment value. Fair market value is the value of the company with no specific investor in mind. In other words, it is the value that the stock should have when offered to a person who has no compulsion to buy or sell a stake in the business. Fair market value is a point of departure in determining the share price.
These calculations offer an excellent departure point to test the viability of a listing
Investment value is determined with a specific buyer in mind – in other words a buyer who is keen to acquire a strategic stake in the company. Strategic corporate deals are generally worth around 30% more than fair market value.
Once the influences have been considered, there are nine steps an investor can follow to determine a company’s market value.
Step 1: Choose a valuation method
The method chosen to valuate the business is determined by the judgement of the owner, but most follow the free cash flow method. In the simplest terms, this is the operating pre-tax income of the company. Deductions that are considered once-off, such as bonuses and interest-bearing debt, are not deducted from this figure.
This figure gives investors an idea of the amount of money that is available to grow the business and therefore grow
their investment.
The business must also decide whether to do the valuation on the previous year’s statements alone or on an average over a number of years. Often, when an average is taken, more recent years are given a larger weighting towards the total average.
Step 2: Choose a capitalisation rate
This step determines the rate of return an investor can expect, relevant to the inherent risks associated with the company. The higher the risk, the greater the expected return will be.
An appropriate rate can be determined by comparing the price earnings ratios (PE) of other listed companies in the same field. PE is the price of the share, divided by its earnings. The figure represents the number of years a share’s earnings will take to pay for that share. The more earnings generated, the lower the PE will be.
If other companies in the same industry have a PE of around 10 times, potential investors will look for the same value for their money in a new business. If they are unsure if this can be achieved, they will only invest if they can expect a lower PE.
Step 3: Divide the free cash flow earnings stream by the capitalisation rate
Dividing the figure determined in step 1by the figure determined in step 2 produces a tentative fair market value of the business.
Step 4: Review the balance sheet
It is important that the strength of the balance sheet can be calculated to allow further analysis of the company. While the cash flow generated by the company is vital in determining its growth prospects, the balance sheet lets investors know that the company possesses the necessary working capital and fixed assets to support its operations. Stronger balance sheets attract more investors, especially in the case of smaller, newly listed companies that may not be well known.
Investors also look at the amount of debtors and creditors on the balance sheet. Too many debtors could mean a large amount of bad debts in the future, while too many creditors could put the brakes on future cash flow. Companies that are considering a listing should consider how their debtors and creditors books can affect the valuation of their company and address any shortcomings.
Step 5: Gross fair market value
Based on the strength of the balance sheet, the figure calculated in step 3 is adjusted upwards or downwards to arrive at the company’s gross market value.
Step 6: Deduct interest-bearing long-term and short-term debt
The free cash flow determined in step 1 calculated the amount of money going to debtors and those with an equity stake in the company. To determine a price for those shareholders not interested in acquiring a strategic stake in the company, the amount of interest-bearing debt must be subtracted from the gross fair market value determined in step 5.
Step 7: Arrive at net fair market value
The calculation in step 6 determines a company’s net fair market value. This is the last step in setting the price for a non-strategic buyer. For a strategic buyer or shareholder, this is only an intermediate point.
Step 8: Add additional strategic value
This step depends on the interpretation of the entrepreneur and makes room for the addition of any calculations that are deemed to reflect inherent strategic value within the company.
Step 9: Investment value
The result of step 8 is the investment value of the company. Although the help of specialist analysts is necessary to find the exact price to take the company to the market, these calculations offer an excellent departure point to test the viability of a listing.
For more information on taking your company to the AltX, we recommend A guide to AltX, where all the information in this series of articles is contained. It was written by Jacques Magliolo and published by Zebra Press. ISBN: 1868729044.
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