Let’s say I owned a business in the form of a neighborhood shop. To set up that shop, I spent $1,000 last year on equipment and other assets. The equipment and other assets have depreciated by 10% in one year, so now they are worth only $900 in the accounting books. If I were to try to sell you this business, how much would an accountant value it? Simple! $900. The cost of all the assets (less liabilities, if any) will give accountants the “book value” of the business, and this is traditionally how accountants see the worth of a business or company. (We use the word “book” because the worth of the assets are written in the company’s accounting “books.”)
However, what if this company is earning a juicy cash profit of $2,000 per year? You would be getting a mighty good deal if I sold it to you for only $900, right? I, on the other hand, would be getting a pretty sour deal if I sold it to you for only $900, because then I’d get $900 but I’d lose $2,000 per year!
For this reason, financial managers (unlike accountants), do not use only a company’s book value when valuing a business.
So how do they determine how much it’s worth?
Instead of using a business’ books or even net worth (the market price of the company’s assets minus the company’s liabilities), financial managers prefer to base a business’ worth on how much it earns in terms of cash flow (actual cash earned… unlike simply “net income” which might not always be in the form of cash).
In other words, a small business earning $1,000 “free cash flow” per month with assets worth a tiny $1 would still be worth much more than a larger business with large assets of $500 if the large business is earning only $1 per year.
So now, how do we get the exact value of a business? The simplest way is to just get the net present value of all future “free cash flows” (cash inflow minus cash outflow).
Of course, there are slightly more complicated formulas to find the value of a company (which you don’t really need to know in detail, since there are so many free calculators online), but almost all of these formulas are in a way based on the net present value of cash flows, plus they may take into consideration a couple of other factors such as growth rate, inherent risk of the company, and others.
David Michael is the creator of MBAbullshit.com, a fun and free online tutorial website for lots of MBA courses and business school topics. Go to http://mbabullshit.com/blog/2011/08/06/business-valuation/ to watch a super easy step-by-step online tutorial on how to calculate the value of a company in the video How to Value a Company, Business Valuation in 26 Minutes.
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