How To Calculate Company Valuation?

The valuation of a company is an essential factor/parameter of a company. Understanding the company’s value is crucial as the business grows, especially when the company wants to raise capital, borrow money or sell a portion of the business. 

Investors check a company's financial health and future prospects before investing in a business. One of the ways to assess a company before investing is its valuation. However, the company valuation depends on various factors, such as market and industry performance, proprietary commodity or technology, and growth stage. This article provides what is the valuation of a company and how to calculate company valuation.

What is valuation of a company?

The valuation of the company is the technique or process to determine the true worth of the company's stock or the fair value of a business. A company valuation can be defined as estimating a company's fair market or intrinsic value. The company valuation is done after considering several parameters to understand if the company is undervalued, overvalued or at par. 

When the company's market value (the price at which a stock can be sold or bought in the current marketplace) and the intrinsic value (the actual value of the stock based on true value) is determined, one can decide whether to sell, buy or hold a company's stock. When a company's market value exceeds its intrinsic value, one should sell its stock. When a company's intrinsic value exceeds the market value, one should buy the company's stock.

How to calculate company valuation?

There is no one formula or a general formula to calculate or determine the company valuation. There are various company valuation methods based on different approaches. Each approach determines company valuation for different purposes and has different formulas. Let's look at the different company valuation methods individuals can use to calculate company valuation. 

Asset Approach

The Net Asset Value (NAV) is the easiest way to calculate the valuation of a company. The NAV is calculated using the fair value of every depreciating and non-depreciating asset. Every asset is considered since the fair value may differ from the last recorded value for a depreciating asset or the purchase price in the case of a non-depreciating asset. The asset-based approach is used to value a company with high tangible assets where it is easier to calculate the fair value than intangible assets.

Discounted Cash Flow Approach

The discounted cash flow approach estimates the current value of future cash flows by discounting them at an applicable rate. Generally, the Weighted Average Cost of Capital (WACC) is used as a discount rate for arriving at the current value of the cash flows. It estimates the money an investor would receive from an investment. The cash flows are projected for many years and discounted to determine the company's valuation. 

Market Approach

The market approach is also known as the relative valuation method. This is the most common technique used for stock valuation. The value of a stock is determined by comparing the value of a company with similar assets based on metrics like PE ratio, PS ratio, PBV ratio, etc. Since companies differ in size, these ratios give a better idea of their performance. They are used to calculate various parameters of the stock valuation.

PE Ratio (Price to Earnings Ratio)

The price-to-earnings ratio is determined by dividing the stock price by the earnings per share. This is a predominantly used technique to calculate if the company stock is overvalued or undervalued. The profit after tax is used as a multiple to calculate the equity value. The track record of the profit after tax must be considered to get an accurate PE ratio.

PS Ratio (Price to Sales Ratio)

The price-to-sales ratio gives a better valuation of a company compared to the PE ratio. In this metric, the capital structure distortions do not affect the sales figure. It is calculated by dividing the company's share price by the total number of sales. It can also be calculated by dividing the share price by the companies' net annual sales. The PS ratio is useful when the company has no consistent profits.

PBV Ratio (Price to Book Value Ratio)

The price-to-book value ratio is a traditional method of calculating company valuation. It is calculated by dividing the stock price by the stock's book value. However, this metric does not consider the company's intangible assets and future earnings. Thus, industries like banking use this method since their income depends on the value of their assets.

EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation)

The most reliable ratio is the earnings before interest, tax, depreciation, and amortisation. In this metric, the earnings are considered before calculating tax, interest or loan amortisation. The capital structure, non-operating income and tax rates do not distort this ratio.

Company valuation formula

As stated above, there is no one formula to determine or calculate the company valuation. However, the different formulas used to calculate a company valuation under different company valuation methods are given below.

Asset approach formula

The NAV of a company is calculated by subtracting the outstanding liabilities of a company from the fair value of the company assets. 

Thus, Net Asset Value or NAV = Fair value of all the assets of the company - sum of all the outstanding liabilities of the company

Discounted cash flow approach formula

The discounted cash flow is calculated by dividing the current value of the future cash flows by discounting them at an appropriate rate.

Discounted cash flow = 1st-year cash flow/(1+r)^1 + 2nd-year cash flow/(1+r)^2 + ……… + nth year cash flow/(1+r)^n

Here r = rate of interest, i.e. the weighted average cost of capital

PE ratio formula

PE ratio is calculated by dividing the stock price by the earnings per share.

PE Ratio= Stock price/earnings per share

PS ratio formula

PS ratio is calculated by dividing the company's share price by the total number of sales.

PS ratio = Share price/total number of sales

It can also be calculated per share by dividing the share price by the net annual sales per share.

PS ratio = Stock price/net annual sales per share

PVB ratio formula

PVB ratio is calculated by dividing the stock price by the book value of the stock.

PBV ratio = Stock price/book value of the stock

Thus, if the PBV ratio is 4, it means the stock price is Rs.40 for every stock with a book value of Rs 10.

EBITDA formula

EBITDA to sales ratio = EBITDA/net sales of the company

EBITDA will always be less than 1 as tax, interest, depreciation and amortisation would be considered from the earnings.

Company valuation examples

Example 1:

The current market price of XYZ Ltd is Rs.190 per share. The terminal cash flow value is Rs.300 per share for the next five years. The cost of capital is 10%. 

As per the discounted cash flow method, the value per share is Rs.186.27, i.e. Rs.300/(1 + 0.10) ^5]. The market price per share is Rs. 190. The shares of a company can be bought since the market price of the share is lower than its intrinsic value. Undervaluation gives a buying opportunity, while overvaluation indicates selling.

Example 2:

The average PE ratio of the automobile industry is 5. The share price of company ABC Ltd is Rs.100, and the earnings per share are Rs.40. The share price of company XYZ Ltd is Rs.80, and the earnings per share are Rs.10.

The PE ratio of company ABC Ltd is 2.5, i.e. 100/40. The PE ratio of company XYZ Ltd is 8, i.e. 80/10. Company ABC Ltd has a low P/E ratio, and company XYZ Ltd has a high P/E ratio. Thus, company ABC Ltd is undervalued and may be a good buy for an investor, while company XYZ Ltd is overvalued and may not be a good buy for an investor.

Frequently Asked Questions

How to calculate company valuation from equity?

Many market enthusiasts use the market capitalisation method to calculate the company valuation from equity. It is used to calculate the worth of a company as determined by the stock market. To calculate a company’s market capitalisation, multiply the number of outstanding shares by the current market value of one share.

The formula for market capitalisation is as follows:

Company valuation = Share price X Total number of outstanding shares

However, the market capitalisation method only considers equity valuation, while many companies have a mix of equity and debt for financing.  

How to calculate company valuation from revenue?

The valuation of a company based on the revenue is calculated by using the company's total revenue before subtracting operating expenses and multiplying it by an industry multiple.  The industry multiple is an average of what companies usually sell for in the given industry. Thus, if the industry multiple is two, companies usually sell for 2x their annual revenue and sales.

There can also be variations in this company valuation method since some companies may value the company on revenue for the last 12 months, projected revenue for the next 12 months or a mix (6 current months' revenue and six projected months' revenue).

How to calculate company valuation based on investment?

The enterprise value method is used to calculate the company valuation based on the investment. It considers different capital structures, such as equity, debt and cash, to value the company. 

The formula of the enterprise valuation method is as follows:

Company valuation = Debt + Equity – Cash

Since the enterprise value method considers every source of capital, investors can rely on this valuation to neutralise market risks. However, using the enterprise value method to determine the company worth for high-debt industries can lead to incorrect conclusions.

What is the formula for valuing a company?

There is no one formula to determine or calculate the company valuation. Different formulas are used to calculate a company valuation under different company valuation methods. 

Which are the companies with the highest valuation in India?

The top five companies with the highest valuation in India as per the market capitalisation method as of 7th February 2023 are as follows:

• Reliance Industries - With a market cap of Rs.1,563,887 crores. 
• TATA Consultancy Services - With a market cap of Rs.1,266,031 crores.
• HDFC Bank - With a market cap of Rs.921,311 crores.
• Infosys - With a market cap of Rs.660,879 crores. 
• Hindustan Unilever - With a market cap of Rs.620,996 crores.