Though we often look at financial measures, we must never forget the non-financial measures too. These factors can far outweigh any financial appraisal, as it is only based on a company's past track record rather than its future potential.
When putting a value on a company, always consider more than one measure, to allow a 'reality check' on the methods being used.
An obvious starting point for valuing a company is to look at the asset base of that organisation. On this basis the company would be worth its net asset value. There are some limitations to this approach:
Book value - Accountants usually value fixed assets at what they cost, depreciated to reflect the reducing value as items are worn out in use. Book value may not be an accurate reflection of the real value. This can apply when land and buildings were bought some time ago, and have grown in value; or if the value of these assets has reduced significantly since purchase, due to new technologies. There may also be a factor that has previously been ignored, such as environmental issues. Disposal or land remediation costs could wipe out any asset value.
Normally a company will have a fixed asset register that lists all its assets, and the current depreciated book value of those assets. A similar register might also exist for its other assets.
Working capital - Again, we must understand whether these items are accurately stated. Stock (inventory) is usually valued by accountants at what it cost. This may be far more than we can sell it for, especially if it is out of date. Debtors (receivables) is money owed to us by customers. How much of this might be bad debt (i.e. invoices that may never get paid)? Creditors (payables) is money we owe our suppliers. How much has our company avoided paying to improve its cash flow?
Intangible assets - This can take the form of goodwill (the difference between what we pay for an acquisition and what the assets are valued at) or capitalised costs (such as research or start-up costs). As there are no physical assets to underwrite these, the net assets may be overstated if these elements are high.
Investments - There might be some investments in other companies, which accountants will value at what was paid for them, rather than their realisable value in the market.
Unstated assets - Accountants usually put no value in the books on such things as people, brands, intellectual property, market position, forward order book etc. This means that the net asset figure alone might seriously understate the company value. This can apply especially in service-based businesses that have few tangible assets.
Another simple approach is to use a multiplier to calculate a company's value. These multipliers will vary for different industries. One way of deciding what figure to pick for a multiplier is to analyse previous company takeovers within that sector, examining what was paid for these businesses compared to their sales or profit levels.
Caution must be taken in ensuring that the level of sales or profits in the accounting period being analysed is sustainable and does not contain one-off or abnormal conditions.
The sales multiplier uses a multiple of sales to assign a value to that company. This could be less than or greater than 1, depending on expectations for future growth. Sales multipliers are particularly popular in start-up companies that are not yet profitable (eg. dot.com companies).
In the case of the profit multiplier, the multiplier used tends to be greater than 1 and will be based on how many years' future profit are to be factored into the value of a business as well as expectations for future profit growth.
So if a profit multiplier is 10 was used you might expect a 10% return for the next 10 years, with no change in business conditions to pay for this investment.
The value of a company can be ascertained by multiplying the number of issued shares by the current share price. This is known as market capitalisation.
A case for asset stripping? The concept of asset stripping is to buy out a company's shares for less than the value of the assets and then to sell these at a profit. This is why company directors get worried when their share price falls too low!
As already mentioned, there are often non-financial considerations to valuing a company. A scoreboard that balances financial and non-financial measures can be used to help manage a company and also help us value one. Non-financial measures might include:
Health, safety and environment - many companies have policies relating to these factors and would seek an acquisition that might enhance their position in these areas. This could include accident rates, environmental impact and energy usage.
Production measures - these will vary from one industry to another but might include production efficiencies, output per worker, waste levels and how up to date the production processes are.
Intellectual property - the potential value of patents, trademarks and brands.
Employees - the skills, motivation, satisfaction levels, productivity and loyalty of the people who work in the company.
Marketing - geographical coverage, customer satisfaction and loyalty, market share and potential fit with existing activities have a value that can be different for different purchasers. The outlook for future growth might lead to an expectation of a better performance in the future, as could the rate of product and process innovation, and percentage of sales from new products.
Strategic fit - difficult to quantify, and used to justify high acquisition costs! Companies will also claim to be able to gain synergies and cost savings through merging the two organisations.
When considering purchasing a company, another way to value the business is to examine what cash it will generate over a period of time. This can be in straight cash terms not taking into account inflation, price erosion etc. You may also wish to apply discounted cash flow principles to arrive at a net present value (NPV) for the company, or even an internal rate of return (IRR) on the purchase.
Perhaps the most useful way to value it is to estimate the economic benefits that the business will generate in the next few years and then apply the NPV process to them. All valuations based on forecast figures are essentially educated guesses, but this analysis is likely to pinpoint the best opportunity for creating value, if the forecasts turn into reality.