Valuation Methods

When a company is trying to value its business, there are several different ways of doing so. Each method varies in terms of the market the product or services it is dealing with but they are a great aid to either a buyer or seller for expanding their business. Here are the four main methods of valuation.

Discounted Cash Flows (DCF)

A DCF measurement shows a buyer/seller the projected cash flow of a business.. If you take the future free cash flow and apply a discount to it, by using a mathematical model, you will arrive at a current value of the business. If the current value found is greater than the price you are paying, for instance of you wanted to invest in the business, this means the business is very likely to make a profit from your money. DCF can therefore give someone a measure of the potential of the business, whether for the owner’s on security or balancing up a profitable investment.

Market Multiples

This valuation is measured as a factor and tells someone whether the business is valued correctly in relation to the economic environment. The total stock price is divided by the earning of each share in a certain timeframe. Out of this comes an analysis factor. For instance, if the total stock price is £10 and the earning of each share is £2, the market multiple is 5 or, in economic terms, the stock has ‘five times earning’. If this factor is higher, it means that a shareholder will make more profit, therefore a higher market multiple means a more optimistic future for the company.

Net Asset Valuations (NAV)

NAVs are used to find out the value of a mutual fund (one with many contributors) in terms of price per share. Total liabilities are taken away from total assets and this figure is divided by the number of shares in the business. By using this method, a buyer/seller is allowed to see how safe this type of investment is because through this formula, grouping of values is used and this kind of diversifying reduces risk. But more importantly than this is the fact that future earnings are not considered- so the buyer/seller only sees the current status of the business and how the mutual fund compares in the current market, therefore it is still a measure of risk. Hence, the more accurate the figure is to the current market, the safer the investment is likely to be.

Dividends Yield

The final valuation method, Dividends Yield, is very similar to the first method except this shows you the cash flow per pound/dollar. The reason it is similar to the first is they both use the same variables but in different orders. This is a good example:

If two companies both pay annual dividends of $1 per share, but ABC company’s stock is trading at $20 while XYZ company’s stock is trading at $40, then ABC has a dividend yield of 5% while XYZ is only yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement his or her income would likely prefer ABC’s stock over that of XYZ. (Investopedia, 2012) So the higher the yield, the more value the share has in the current market, making it very attractive to a buyer.

In summary, there are many ways to value a business but these four methods will be the most useful. They not only tell you how the business is valued today, but also give you an idea of how it will be valued in the future. Any investor will be able to get a much clearer view of the business they are investing in by using these valuation methods.

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