Corporate valuation answers the question of how much a company is worth. There are standard ratios, tools and methods used by financial analysts to determine a corporations’ worth and whether their stock is undervalued or overvalued. Knowing this is very important when it comes to mergers, acquisition, financial stress and market instability.
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The Common Method
One of the most common ways to determine the value of a company is called the asset-based method that uses the book value of a company’s equity. In other words, it determines the value of the company’s assets minus its debts. Regardless of whether it’s tangible items, such as cash and working capital, or intangible things, such as brand name and reputation, equity is the most important factor. Equity is everything that a company possesses if they were to suddenly stop doing business and making money.
Most accountants prefer to use the traditional balance sheet method. This is an excellent way to quickly determine if a company has more cash on hand than their current market value. First, accountants examine a company’s cash, equivalents and short-term investments. They divide the total number by the number of outstanding shares to measure how much of the current share price consists of just available cash. When it comes to buying a company primarily through cash, this yields a variety of benefits for the new owners. For example, cash can quickly fund strategic acquisitions, product research and development and the costs of acquiring successful executives and business leaders.
Alternative Methods
Another popular accounting measure of value is a company’s current working capital compared to its market capitalization. Working capital is defined as what remains after the current liabilities are subtracted from its current assets. Working capital are funds that a company can quickly access to conduct daily business transactions. Knowing the accurate amount of working capital is essential for businesses that trade and invest. Alternatively, shareholder’s equity is an accounting tool that encompasses a company’s liquid assets such as cash, property and retained earnings.
Shareholder’s equity is an overall measure of the liquidation potential a company has if all of their tangible assets were sold. Shareholder equity helps accountants to value a company when they want to establish the book value, which is official value of the accounting ledger. In order to calculate the book value per share, accountants divide the shareholder’s equity by the number of outstanding shares. Then, they divide the stock’s current price by the book value and find out the price-to-book ratio.
Free Cash Flows
Although most investors don’t understand the principles of cash flow, it is one of the most common measurement tools for valuing public and private companies in the field of investment banking. Cash flow refers to the money that passes through a company minus all fixed expenses during the course of a period of time, such as a quarter or the year. Cash flow is officially defined as the company’s earnings before interest, taxes, depreciation and amortization. Cash flow focuses on the business operations and not on secondary costs or profits. To illustrate, taxes depend on the current taxation regulations in a given year and can dramatically fluctuate.
When it comes to corporate valuation, keep in mind that intangible assets like goodwill and brand loyalty have value, but they cannot be quantified.
