Valuation of a company can be relevant in many contexts. It can be in connection with the purchase and sale of a business, as well as mergers or demergers, generational changes and other reorganizations. In all cases, however, the goal is to find what independent parties are willing to buy and sell a business for. This is determined by the parties in negotiations, but there are nevertheless some recognized principles for business valuation that can be used as a starting point. Let's take a closer look at why and how you can make a valuation of your company.
What determines the market value of a company?
Valuing companies is not an exact science. You can often get the impression that it is when you read detailed valuation reports. But companies are like anything else: The price is determined by the market. What a company is worth is determined by the buyer and seller in a specific transaction. There may be many reasons why the buyer will pay what they want, and just as many reasons why the seller will sell for a certain value. It can be compared to property sales. The valuation is a starting point, while the actual market value is determined by what the buyer and seller are willing to pay/sell for.
What is considered the future return on the company?
What determines the price for a buyer, and for that matter also the seller, is how much they can earn on the company in the future. What they can expect as a return on the purchase price. If you're selling, it's therefore essential to visualize the potential of the business. Highlight things you're not good at and that can be done better. Talk about untapped opportunities in the market, potential for growth and how you can improve profitability.
You must also emphasize that the risk is low. That liquidity is good, the scope of assignments is secured, employees are motivated, the organization is well-tuned and that growth and profit improvements are easily achievable.
If the buyer believes in these two things, increased profitability and minimal risk, then you have laid the foundation for a high valuation of the company.
Also read: Useful Due Diligence advice when selling a business
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As a seller, it's tempting to argue in favor of the company's future potential. After all, that's what the buyer is taking over. But keep in mind that the buyer is largely basing their assessment on what the company has delivered in the past. Historical results provide a concrete picture of the company's carrying capacity. If the company has had low profitability over time, it is unlikely that the buyer will pay a high price based on faith and hope for better times. Even if the buyer sees opportunities for improvement, it's not a given that you as the seller will get paid for the value, they themselves must create.
It is therefore important that you visualize the potential of your business, and document with historical figures that you can exploit this potential. Because that's what buyers want: A business with potential.
Methods for valuation
Although value is determined by what the buyer and seller are willing to pay/sell for, there are some recognized methods for business valuations that allow the parties to have a starting point for negotiations. A price expectation. Just like when you go on a viewing in your new home. The methods can be divided into what we call balance sheet-based and what we call profit-based.
In the balance sheet-based methods, the company is valued at the sum of the value of the company's assets. This works well where the company's value is linked to physical assets, typically real estate. But it works poorly where the value is linked to expertise, an established organization or other intangible assets. The value of such a company is not determined by the value of desks and PCs. This is where performance-based methods work best: In other words, methods where the value is determined by the company's ability to make money.
Balance sheet-based models
The balance sheet-based models can be divided into liquidation value and net asset value. The liquidation value is in the word. It is the value of the company if you think it will be liquidated, and all assets are sold. As a rule, it's not that interesting. In the event of the liquidation of a company that operates as a consulting engineer or IT consultant, the sales value of office furniture and other office equipment is close to zero.
If you're winding up a shop, clothing store or interior design business, you usually must sell your goods on sale. In this case, the liquidation value is lower than the value if you had continued the store and were able to sell the goods at full price.
The example illustrates the difference between liquidation value and net asset value. The liquidation value is the value of selling the goods at a sale on discontinuation, while the net asset value is the value if you sell in the usual way at full price. The same item can therefore have two values: a liquidation value and a net asset value.
Performance-based models
Except for real estate, where the value of the company is linked to the value of the property, the most common valuation models are based on profit. In other words, what the business can earn - or provide in return - in the future. That's why we refer to these models as income capitalization models.
In all return-based models, we start with two factors: Expectation of future results and a perception of the risk of achieving these results. In other words, return multiplied by a required rate of return. If the business generates a profit of 100 and the required rate of return is 10 per cent, the business is worth 1,000.
There are few absolute models for determining future earnings, and it is entirely up to the parties themselves what they want to base their valuation on. However, it is common, and so common that it has become an established view, to assume that historical results provide the best expression of what the future will look like.
The starting point is therefore usually a weighted average for recent years, adjusted for inflation and extraordinary items. It is up to the parties to clarify which extraordinary factors can be corrected for, but the seller often believes that weak results in recent years are due to extraordinary factors. For example, weak results in 2020 and 2021 can typically be explained by COVID-19. However, it's up to the parties to clarify how much this means.
Once you've decided what kind of normal result you can expect going forward, you need to determine the required rate of return by which this normal result should be multiplied. This can be done in several ways. You can use comparable transactions where you know the figures as a starting point. If you know that the neighboring company, similar to yours, was sold for 2000 and had results of 400, then you know that they were paid 5 times profit. If your company has a normal profit of 600, you should be able to sell for 3,000.
Alternatively, if you don't know the figures from any comparable transactions, it's common to build up a required rate of return yourself. We start by looking at the risk-free return in the market, typically the interest rate on a government bond. We then add an interest rate for the risk of investing in a company, which can make a profit or a loss. We can divide the risk into financial risk related to the company's financial position and business risk related to the company's ability to make money. It's not uncommon for these risk add-ons to give us a required rate of return of 10% to 20%. If it's 10%, your business, which has a normal profit of 600, is worth NOK 6,000. If the required rate of return is 20 per cent, the business is worth 3,000. In other words, the choice of required rate of return has a major impact on the valuation.
What is the company's share value?
In addition to the uncertainty of valuing the overall business, there is a significant element of judgement when determining the value of the shareholding you own. If you own 10 per cent of a company that is valued at 1,000, this does not mean that your shares are worth 100. You must be prepared to give a significant discount for lack of influence in the company, and for the fact that such a shareholding in an unlisted company is often difficult to trade. This is what we call a minority and liquidity discount. The size of the discount depends on a specific assessment of, among other things, the size of the shareholding, how many shares the buyer already owns, the company's dividend policy and how marketable the shares are. In practice, however, you should expect at least a 30% to 50% discount if there are buyers for your shareholding at all.
Summary: Valuing a company is not an exact science
As mentioned, valuing a business is not an exact science. It's not the case that a business valuation can give you a straightforward answer to what your business is worth. But it can help you in negotiations and, not least, help you decide whether you should keep the company and realize the results you believe in. As I said, the value depends on the belief in future results and the risk of achieving them. If you can't convince a buyer of the potential, perhaps it's better not to sell?
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