There are many reasons to conduct a business valuation. For example, it is necessary to determine the value of a company for the purchase or sale of a company or for taking on additional shareholders. Moreover, business valuation regularly plays a decisive role in company succession. If, for example, the company is bequeathed or gifted, a business valuation is relevant for the calculation of inheritance or gift tax. A business valuation is also often necessary for other tax purposes, e.g., in the event the entrepreneur moves away from Germany (exit tax).
It is clear that all tangible assets such as land, machinery or any recoverable receivables from third parties must be included in the valuation of a company. In addition, intangible factors, such as the company's respective industry, specific expertise of the employees, the company's earnings, its future prospects, the composition of the customer base but also the current market environment and, last but not least, supply and demand, also play a role in determining value.
There is no single correct value of a company, nor is there only one type of value. Likewise, there is not ONE single correct method for business valuation. In fact, various valuation methods have emerged and proven themselves in practice. The following are the most common valuation methods:
The asset value method focuses on all tangible assets of the company. In this, all machinery, real estate and other inventory, among other things, are used to determine the value of the company. From this value, all the company's liabilities (e.g., personnel costs, outstanding receivables to be paid) are deducted and a corresponding company value is formed.
This method is used, for example, in the purchase or sale of businesses that have a large inventory of valuable machinery or land or real estate. The main advantage of this valuation procedure is its clarity. A decisive disadvantage, however, is the lack of consideration of intangible items (e.g., image and prominence of the company, existing customer base) and future earnings forecasts.
The income capitalization approach is linked to the determination of the earnings of a company that the buyer can expect in the future. It is therefore an approach that determines the value of the company based on a forecast of expected revenues.
The income capitalization approach is simplified in the following four steps:
- The operation result, i.e. the company's profit or loss from ordinary activities, is determined for a period of the past three years. Extraordinary income and expenses are not taken into account.
- The future expected profit of the company is determined. This is based on the average of the company's adjusted earnings from previous years.
- Subsequently, a capitalization interest rate is determined. This is composed of the interest rate of a risk-free investment (base rate) and a risk premium. The amount of the surcharge depends on the specific circumstances of the company. Conversely, the higher the capitalization rate is, the lower the company value is.
- The company value is determined in the final step. This is achieved by dividing the future expected earnings by the capitalization rate. Or in other words: The company value is calculated by multiplying future earnings by a specific multiplier (100 divided by the capitalization rate).
The advantage of this calculation method is mainly the opportunity to consider the profit forecasts. In addition, it is possible to simulate various future scenarios by adjusting the values. On the other hand, the earnings achieved in the past do not guarantee that the company will achieve the same or even better profits in the future. In particular, future developments in the market cannot usually be predicted with certainty.
The multiplier method is a valuation method based on the current market. This makes it possible to incorporate an industry reference as well as the current market environment with comparable companies within the scope of the business valuation.
Only two values are required for the method. First, a key performance indicator of the company must be determined. This can be, for example, revenue or the company's earnings before interest and taxes (EBIT). Next, introduce a multiplier. This provides the point of intersection compared to other companies from the same industry. Accordingly, the amount is determined on the basis of comparable companies on the market. Once the factor is determined, it is multiplied by the company's KPI to determine the value of the company.
This method is distinguished by its simplicity. In addition, an orientation to the market price is carried out based on the market-related multiplier of the respective industry.
The particular circumstances of the company to be valuated and the purpose of the valuation shall determine which valuation method should be used or, if necessary, must be used for legal reasons. Since there is no single "correct" valuation method, nor can a single "true" company value be determined, each method has its own advantages and disadvantages. In this respect, seeking advice from experienced experts is recommended.
Do you have questions about business valuation? Are you planning to sell your company or would you like to buy another one? Are there inconsistencies in the application of the valuation methods?
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