I was recently asked by a friend of mine how to accurately value a company. I guess my answer is that 'There is NO such thing as being able to ACCURATELY value a company!' However, there ARE standard methods by which to get an IDEA of value. The value of a company can really only ever be accurately obtained by what someone is willing to pay for it.
In my time I have purchased around 40 small Internet companies, a bar, a Barter company, and various small other companies. I have also then sold a large internet company (the aggregation of all the small ones), and the other companies off again.
When I am looking to purchase companies, I generally use a variety of valuation methods in combination, as one by itself is often not reliable. The valuation methods I most commonly use are:
- Assets minus liabilities (net position)
- Price / Earnings multiple
- Seeby's patented 'heads and eyeballs method of valuing an Internet company'
- Discounted Cashflows
ASSETS MINUS LIABILITIES METHOD
This valuation method is very simply explained as: add up all of the things the company owns (assets), subtract what it owes (liabilities), and then you can come up with a figure. Say for example there was a company that owned $4M of residential properties, and had $1M of mortgages. It would be pretty fair to say that the value of the company was about $3M. However - this valuation method can break down or be incorrect at times. For example - say you had a property company that owned $100M of commercial property, and had $100M of debt. If the property was returning $10M a year in rents (a yeild of 10%), and had costs on the debt of 5% ($5M a year), then this company would be making $5M per year. Clearly the company has a zero net asset position, but is not worth 'zero', as a $5M per year cashflow would be very nice! (The fact that the company is highly geared and may fall over because the bank decides to withdraw funding is another matter again which should be taken into account)
PRICE EARNINGS MULTIPLE
This valuation method is explained as: Take the money that the company makes each year, and then multiply that by some factor in order to work out the value of the company. If you had a company that was making $5M per year (as in the example above), you would expect that it was at least worth $5M (unless under risk of imminent closure), because you could buy the company, and then you'd have your money back in a year, after which you get money for jam. Personally, I like to buy companies at multiples of around 3x earnings, and sell them at multiples around 5x earnings, but companies are bought and sold on earnings multiples all the way from 1 to 100 or sometimes even more depending on all sorts of other factors. This valuation method might fall down or be incorrect where you had a company that had lots of assets and no debt, but didn't make much money. Think of a company that owns $100M of residential property with no debt, but none of the houses is rented out, so there is no income. Clearly it's not a great business from an income perspective, and close to zero from the p/e multiple valuation, but it's probably worth close to $100M.
It's worth noting that a comon way that people such as Eric Watson, Graham Heart and other corporate raiders and leveraged buyout guys make huge amounts of money, is by buying companies that are valued in traditional ways such as described, but then they either break them up and sell off the pieces, or re-package them in such a way that a different valuation method can apply, that allows previously hidden value to be unlocked, and then retained.
I myself have been researching a public company that has a net asset position of $20M, and solid earnings, and yet it's 'market cap' or net worth on the share market has dipped to just $10M because investors are scared of even good businesses right now. This means that if I was able to successfully buy the whole business for $10m, I could sell off the assets and I'd get $20M back (and $6M of their $20M of assets is just cash in the bank, so that would come back instantly). Companies like this are said to have a higher 'asset backing' than market cap - which is rare, but is definitely a good thing, because it means that if the company went out of business, the value of the assets sitting there is more than what you could purchase the company for. It's like buying a company for $500,000 that happens to own a $2M house with $1M of debt, and is therefore worth $1M, but no-body has picked it up - perhaps because the business isn't 'sexy'.
SEEBY'S 'HEADS AND EYEBALLS VALUATION METHOD'
This method I developed myself after 5 years of doing deals to buy Internet companies. It is useful when the other two methods above break down, and can be used to find or justify hidden value. Most often it applies to Internet and tech companies, but doesn't need to. If you think of a company such as Netscape back in the Dot Com Bubble days, they didn't really have many assets other than a bunch of computers and desks (so wouldn't have been worth much on an 'assets' basis), they didn't have much revenue because they gave their product away (so they weren't worth much on a p/e basis), in fact all they did was lose buckets and buckets of money, and yet the sharemarket at various times valued them at hundreds of millions of dollars. The reason for this huge valuation was because of all the 'eyeballs' that they could control, which is an opportunity for future sales. Instinctively you would know that if you had a company that could advertise to almost anyone on the planet, and yet didn't have any assets, and didn't make any money, that it would still be worth a lot because of the potential to up-sell, move into different markets, evolve the business model etc. This is what Netscape was, but ultimately they didn't evolve - if they had evolved into Google in time, then their investors would have been very rich instead of losing their shirts. Using my own more complex inputs and this valuation method, I was able to accurately identify Internet companies that had hidden value that I could sell for a higher price, but that could be purchased for a low price based on traditional valuation methods.
The discounted cashflow method of valuing a business basically takes into account the time value of money, and works out what future income streams are worth today. The discounted cashflow model might be usefull for valuing a company that has no income, no assets, but has a business plan that is likely to succeed and shows considerable growth in the future. Wikipedia probably does a better job than me explaining this, so have a look at their article on the subject