The four most important methods for calculating the enterprise value for small and medium-sized companies are the multiple method, the asset value method, the earnings value method and the DCF method. Here’s what you should know about each method. Simply explained and with examples.
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The multiple method
For an overview of our current Market data on valuation multiples .
Valuation = basic key figure multiplied by the valuation multiple
The multiple method (also known as the “multiplier method”) is a method frequently used in the area of mergers and acquisitions. The method allows a quick check of whether a purchase price expectation for a company sale is realistic and appropriate on both the buyer and seller side.
The current prices achieved by comparable companies that have already been sold are used. One examines the multiple (“multiple”, “multiplier”) for which these companies were sold and applies this factor to the company to be valued. Multiples can, for example, be multiples of operating profit (“EBIT multiple”), earnings before interest, taxes, depreciation and amortization (EBITDA multiple) or sales (“sales multiple”).
The method is primarily suitable for companies that have been in existence for a long time. Here, a multi-year profit development can be used as a basis for valuation. The better the empirical values, the more meaningful the result will be. In any case, it is advisable to use the multiple method in addition to the plausibility of a company value that has been determined using another method.
The indicative value of the company determined using the multiple corresponds to the “enterprise value”. This is the value of equity plus financial debt. This means that to determine the value of equity, financial debt must be deducted from the determined company value.
Valuation using the EBIT multiple method
When valuing a company using the EBIT multiple method, the average net earnings before interest and taxes (“EBIT”) of the last few years are multiplied by the EBIT multiple. The focus is on earnings before interest and taxes so that the multiples remain comparable even for companies with different tax rates and debt structures. For smaller companies with sales of up to 20 million, the observed range for multiples is mainly in the range of 4 – 10. A multiple of 6 or higher means that the company is highly attractive. Where the company is located within the range depends not only on the numbers but also on numerous “soft factors”.
NIMBO uses EBITC multiples to value companies
The EBIT plus the total managing director compensation (gross salary, employer contributions to social security, car expenses) is taken as the basis.
In smaller companies, the managing director can determine his own salary within certain limits. The “EBITC” allows a comparison with the profitability of other companies without distortions caused by wages that are above or below the market wage, peculiarities in capital structures and different tax rates. The EBIT variant also includes an adjustment of the managing director’s salary, but NIMBO prefers the EBITC variant because, from an empirical point of view, it can explain observed purchase offers better than the EBIT variant.
Valuation using the EBITDA Multiple method
In contrast to EBIT, EBITDA (earnings before interest, taxes, depreciation and amortization) does not take depreciation and amortization into account. For the same EBIT, the EBITDA of an asset-intensive company can be significantly higher than that of a personnel-intensive company.
For capital-intensive companies with a high intrinsic value, it makes sense from a buyer’s perspective to work with EBITDA multiples, as the level of depreciation allows a certain amount of leeway, which can distort the result. The phase of the investment cycle the company is currently in should always be taken into consideration. Are investments pending?
Valuation with sales multiples
From an investor’s perspective, the potential profit of a company is particularly interesting. However, if the current profit is not meaningful, very small or even negative, another key figure, such as sales, should be considered. This can make sense, for example, if the buyer believes that it can improve its return on sales with its own existing, more efficient cost structures. With this method, the potential buyer takes a greater risk and must believe that the company will make profits in the future.
A sales multiple valuation can also be used in addition to or to verify the plausibility of other valuations.
Sales multiples are significantly smaller than EBIT multiples. The observed range is usually between 0.2 and 2, depending on the industry, profitability, growth prospects and some other factors. For slow-growing and little or not profitable companies, sales multiples between 0.2-0.6 are realistic. Depending on the level of sales, a change in the sales multiple by a factor of 0.1 can have a major impact on the company’s value.
If a valuation is carried out using both EBIT and sales multiples and the valuation using the sales multiple results in a higher value than the valuation using the EBIT multiple, this indicates a lower return on sales than that of comparable companies.
Example Multiplier Method
Example assumptions:
EBIT: €1,000,000
Industry-typical multiple: 4-7
Assumed multiple (because the company is doing better than average): 6
Bank loan: €1,000,000
Higher than usual inventory: €500,000
Calculation of the company value:
Step 1: Calculating the Enterprise Value (EV)
Enterprise Value = EBIT × Multiple
EV = €1,000,000 × 6 = €6,000,000
Step 2: Calculating the Equity Value
Equity Value = Enterprise Value – Net Liabilities
Net Liabilities = Bank Loans – Excess Inventory
Net liabilities = €1,000,000 – €500,000 = €500,000
Equity Value = €6,000,000 – €500,000 = €5,500,000
The enterprise value is: €6,000,000
The equity value is: €5,500,000
Advantages and disadvantages of the multiplier method:
The net asset value method
Valuation = intrinsic value of the company
This is the simplest method to determine the intrinsic value.
The values for fixed assets and current assets are added at market prices from the balance sheet, adjusted for hidden reserves and taxes, debts and liabilities are deducted.
The net asset value shows a rather low company value.
In the event that the intrinsic value does not yield interest that is appropriate to the risk or the company even makes a loss, the financial value of the company – without any value-enhancing synergy effects with a potential buyer – is basically equal to the liquidation value.
In connection with the sale of a company, the intrinsic value has primarily an informational value and is usually below the valuation range of the multiple methods, since no goodwill and earnings potential above the minimum interest rate are reflected.
Advantages and disadvantages of this method
It can be quite useful to use the net asset value method as a supplement, for example in combination with a more optimistic method such as the earnings value method (see section on mean value methods) .
It quantifies the current value of the company’s existing assets and shows the actual amount of equity. This is important for financing.
Example of the Net Asset Value Method
Example assumptions:
Value of fixed and current assets (at market prices): €1,000,000
Liabilities/Debts: €500,000
Provisions: €100,000
Release of economically unnecessary provisions: €100,000
Calculation of the intrinsic value:
Step 1: Adjustment of provisions
Economically unnecessary provisions are released:
Effective provisions = provisions – unnecessary provisions
Effective provisions = €100,000 – €100,000 = €0
Step 2: Net asset value = assets – liabilities – effective provisions
Net asset value = €1,000,000 – €500,000 – €0
intrinsic value = €500,000
The net asset value of the company is: €500,000
Importance of the net asset value method
The net asset value method plays only a minor role today. The advantages are clearly the ease of use and the good traceability of the results. The low informative value is a negative for many companies, as intangible assets and future developments are not taken into account.
simplified income approach
Valuation = yield divided by capitalization rate
When valuing a company using the income approach, the company is viewed as an investment that generates constant returns. These constant returns are valued according to the financial mathematical formula of a perpetual annual income stream. The average, expected, sustainable profits after taxes over the next three to five years are divided by a risk-adjusted interest rate (“capitalization rate”). The value thus determined is the value of the equity (so-called “equity value”).
Since the income approach is based on forecasts, the underlying values should be as realistic as possible. The result should also be checked for its sensitivity to changed assumptions (e.g. lower/higher yield and interest rate). The question always arises as to the extent to which the existing profitability of the valued company can be transferred to the buyer in the event of a sale.
Machinery or inventory that is necessary for normal operations is already included in this calculation, as it is a prerequisite for achieving the sustainable income on which the valuation is based.
Calculation of capitalization interest
Capitalization rate = base interest rate plus market risk premium plus company-specific risk premium
The capitalization rate is made up of three factors.
The base interest rate, also called the risk-free interest rate. It is usually the interest rate on government bonds with a maturity of 10 or 30 years. At the end of 2021, the base interest rate in Germany was rounded to 0.10%.
The market risk premium, which reflects the entrepreneurial risk in the relevant industry and country.
The company-specific risk premium, which assesses the company’s specific business risks.
For example, an interest rate of around 20% is usually realistic for the valuation of a craft business due to the often higher dependence on the owner. This has been empirically proven by real purchase prices.
Factors for determining the risk premium
Fungibility : The company can be monetized quickly, safely and without high costs. This is generally not the case for non-listed companies.
Role of the business owner: The business is very dependent on the business owner. All decisions and contacts are focused on him.
Company strategy: There is no comprehensible short, medium and long-term strategy.
Competition: Competitive pressure is high and as a small company with a small market share there is an increased risk of margin pressure or even being forced out of the market.
Customer structure: A large part of the turnover is made with a few customers. There are hardly any barriers to switching for customers. The customers have aged with the owner and will no longer be there in the foreseeable future.
Supplier structure: There may be supply bottlenecks or delays in production due to dependence on individual suppliers and there are no alternative options.
Management: It is insufficiently qualified and/or experienced. There is a risk that it will leave the company after a change of ownership.
Employees: The level of training of the employees is rather low. Suitable skilled workers are difficult to obtain on the labor market, which has a negative impact on future growth. There is a dependency on some key people who are not easily replaced.
One-off sales: Sales are mainly generated from non-recurring customers.
Example of simplified earnings value method
Example assumptions:
Sustainable return (average of adjusted profits of the last 3 years): €1,000,000
Base interest rate (risk-free interest rate): 2%
Market risk premium (market premium for the industry): 8%
Entrepreneur-specific risk premium (above-average risk due to dependence on the owner and the size of the company): 10%
Question from the buyer’s perspective:
How much money would the buyer have to invest in an alternative investment with the same risk to achieve a return of €1,000,000?
Calculation of the capitalization interest:
Step 1: Capitalization rate = base interest rate + market risk premium + entrepreneur-specific risk premium
Capitalization rate = 2% + 8% + 10%
capitalization rate = 20%
Calculation of the company value (earnings value):
Income value = Sustainable income / capitalization rate
Income value = €1,000,000 / 0.20 = €5,000,000
The capitalization rate is: 20%
The company value is: €5,000,000
Advantages and disadvantages of this method
Importance of the income approach in Germany
In Germany, the income approach is the most widely used method (IDW S 1). It is the valuation procedure prescribed by law for company valuation for inheritance and gift tax. The income approach is used accordingly by the tax authorities and is widely accepted in legal disputes.
The Association of Valuation Consultants in the Craft Sector has developed the AWH Standard for the valuation of small and medium-sized craft businesses. It is also based on the income approach and is adapted to the specific characteristics of these companies. Further information on assessment according to the AWH standard is available from the ZdH.
The Discounted Cash Flow Method (DCF)
This method has its origins in classical investment calculation. Internationally, this is the most well-known evaluation method.
Theoretically, the DCF method provides the most precise company value. The crux of the matter, however, lies in the need to project detailed future earnings or cash flows and the corresponding risk-adjusted interest rates (cost rate) in order to discount them to their present value.
The advantage over the income approach is the high level of flexibility, since one does not have to assume only a single “sustainable yield”, but one can also forecast the course of the earnings situation separately for the next five years, for example. However, this also increases the complexity and the need for explanation of the assessment.
The DCF method is more suitable for determining the value of large companies. The starting point is always a business plan for the next 5-7 years. This method tends to result in higher company values.
In contrast to the income approach, which takes future earnings as a starting point, the surplus payments, so-called cash flows, are considered here.
A distinction is made between the gross or entity method and the net or equity method. In practice, the entity method is mostly used to determine the enterprise value, i.e. the company value including financial debt.
The company’s free cash flow, including interest on debt, is discounted to the present day using the weighted cost of capital of the financial resources tied up in the company. The purpose of calculating the net present value is primarily to reflect the operational potential of a company.
Where possible, an entire investment cycle should be considered, since investments in current and fixed assets have a significant impact on cash flows.
The forecast of cash flows and the choice of discount factors are adjustment screws that can be used to move results in the desired direction. To ensure the reliability of the results, a sensitivity analysis that shows the impact of changes in the assumptions on the company’s value is essential.
The choice between the DCF method and the income approach has, in principle, no influence on the valuation result under the same premises. The decision for one of the evaluation methods should therefore depend on the target group and the purpose of the evaluation.
Example Discounted Cash Flow (DCF) method
Free Cash Flow (FCF) for the next 3 years
| forecast year 1 | forecast year 2 | forecast year 3 | |
|---|---|---|---|
| Free Cash Flow (FCF) | 300.000 | 330.000 | 360.000 |
Calculation of Discounted Cash Flows and Terminal Value
Discount rate (r) = 10%
Terminal growth rate (g) = 2%
DCF 1 =
FCF 1
(1 + r) 1
=
300,000
1.10
= 272,727
DCF 2 =
FCF 2
(1 + r) 2
=
330,000
(1.10)2
=
330,000
1.21
= 272,727
DCF 3 =
FCF 3
(1 + r) 3
=
360,000
(1.10)3
=
360,000
1.33
= 270,676
Calculation of the terminal value (TV)
The terminal value is calculated as:
TV =
FCF 3 × (1 + g)
r – g
=
360,000 × 1.02
0.10 – 0.02
= 4,590,000
The terminal value is then also discounted:
DCF TV =
4,590,000
(1 + r) 3
=
4,590,000
1.33
= 3,451,128
Total Enterprise Value (EV)
EV = Total DCF + DCF TV = 272.727 + 272.727 + 270.676 + 3,451.128 = 4,267.258
Calculation of Equity Value
The equity value is calculated by subtracting net debt from the enterprise value:
Equity value = EV – debt + cash
Suppose the company has 500,000 in debt and 200,000 in cash:
Equity value = 4,267,258 – 500,000 + 200,000 = 3,967,258
The equity value is therefore 3,967,258.
Advantages and disadvantages of this method
Various averaging methods / mixed methods
Due to the estimation of values, the income approach is associated with uncertainties. The combination methods also include the company’s substance in their assessment.
The idea behind the averaging methods is to take into account both the past and future expectations and risks. This leads to a high level of acceptance, especially among companies in the SME sector. Trading and craft companies and companies in the manufacturing industry use it for planned transactions, but it is also frequently used in family succession planning.
The result is based on the weighted average of asset value and earnings value. Weighted usually means that twice the earnings value is added to the intrinsic value. The result divided by three and increased by non-operating assets gives the company value. However, alternative methods are also used in which the shares of substance and income in the total value are weighted differently.
The mean value method or Berlin method
The mean value or Berlin method calculates the arithmetic mean of the earnings value and the net asset value. It is based on the idea that companies with weak assets and high profits are typically exposed to high competitive pressure, which will foreseeably reduce these profits in the future.
Valuation = (income value + net asset value) / 2
The Vienna Procedure
The Vienna method also calculates the arithmetic mean of the earnings value and the net asset value (asset value). However, the calculation of these two values differs from the Berlin method, for example.
The generalisation of the factors that are most difficult to determine makes the Vienna procedure a simplified procedure. The capitalization rate is set at nine percent. The uncertain forecast of future earnings is avoided by taking the average of the last three financial years. The Vienna procedure is often used as an alternative procedure when the parties cannot agree on other valuation methods.
Valuation = (income value + net asset value) / 2
The excess profit method
The excess profit method is another averaging method and is based on the assumption that in the long term the profit only corresponds to an appropriate return on the asset value.
As a result of the consideration that higher profit margins decline over time, excess profits that exceed the normal interest rate are capitalized at a higher interest rate. Factors that can be responsible for a decline in profits include, for example, a weaker economy, increased competition, etc.
Example calculation excess profit method
Example assumptions:
Two things must be determined for the valuation:
1. The level of interest at which the asset value is sustainably compounded (“normal interest rate”).
2. Number of years for which the excess profit is to apply, which is added to the net asset value.
The interest on the asset value tied up in the company at replacement prices at the normal interest rate is deducted from the effective profit. This “excess profit” above the normal interest rate is added to the asset value over a certain number of years. Typically, a period of 3-8 years is used.
VALUATION
= net asset value + present value of excess profits
= net asset value + number of years with excess profit x (profit – (normal interest rate x net asset value))
= Numerical example: 1,000,000 + 3 x (200,000 – (10% x 1,000,000)) = 1,300,000
The Swiss method or the practitioner method
The practical method is easy to understand and follow and is often considered the first point of reference on both the buyer and seller side.
For successful companies, the practitioner method leads to very conservative, low values for the company.
The Swiss tax administration also uses this valuation method. It assumes a capitalization rate of 9.5%.
Valuation = 2/3 x earnings value + 1/3 intrinsic value
The Stuttgart procedure
In the Stuttgart method, the value of a company is calculated from the sum of its intrinsic value and its earnings value. This method was primarily used to determine the enterprise value of non-listed companies in the event of inheritance or donation. Since this procedure is no longer up to date, it was abolished in 2009.
special cases
Special case: Low yield with a lot of substance
The Schnettler method deals with the special case of low-yield or unprofitable companies with high asset value that do not pay adequate interest on their assets. It is my mixed method of intrinsic value and earnings value.
The depreciation on the high level of property, plant and equipment results in accounting losses. A buyer would record the property, plant and equipment at reduced replacement cost, thereby reducing depreciation and increasing the capitalized value accordingly.
Frequently Asked Questions
What is the best method for company valuation?
Depending on the reason for the valuation and the phase the company is in, one method or the other may make more sense. We recommend trying out several methods to get a feel for the range within which the value moves. Nimbo works with the multiple method.
How does the multiple method work?
This method requires recently achieved prices from comparable companies as a basis for calculation. One examines the multiple (“multiple”, “multiplier”) for which these companies were sold and applies this factor to the company to be valued. Multiples can, for example, be multiples of operating profit (“EBIT multiple”), earnings before interest, taxes, depreciation and amortization (EBITDA multiple) or sales (“sales multiple”).
What method is used to evaluate a start-up?
A start-up that is not yet making a profit and is growing rapidly is seen as having promise for the future. The DCF method can be applied to business plans of start-ups. The discount rate used is derived from the investors’ expected return.
Who is the multiple method (multiplier method) suitable for?
This method is primarily suitable for long-established, profitable companies. Here, a multi-year profit development can be used as a basis for valuation. The more stable the empirical values, the more meaningful the result will be. This method is not suitable for companies that are making losses or are in a strong growth phase.
