How to value a company?

An investor should know how to value a company and if the price they are paying for the company is worth it.It is important for both retail investors as well as huge investment companies as a wrong valuation would implicate huge losses for them.Therefore before buying any asset or investing into any company the investor should first value it.The most important reason is to know if a company  is getting good value for the company.Learning how to value a company would be quite useful for any individual if he learns how to ripe the benefit of it

Broadly there are three ways or approaches to value a company.They are as follows:

• Asset Based approach
• Ratio Based Approach
• Discounted Cash Flow(D.C.F)

These methods to  value a company don’t give the exact number from each method they give a range.The range would the justified amount which the prospective buyer or investor should use as a measuring tool.The lower end would be more appealing for the investor but not so much for the seller.The upper end in turn would be more appealing for the seller and less to the buyer.The actual price at which the transaction happens depends upon the negotiation skills and ability .Somewhere close to the mid-range is usually appealing for both the parties.

Asset Based Method/Approach

In this method the balance sheet of the company is taken as the starting point and look at the assets and liabilities.Then,make some adjustments in the balance sheet in terms of the risk the asset carries,the depreciation that should be charged to it and other likely expenses that you might incur in the near future.This would give the valuation of a company according to the value and type of asset the company you are looking to buy,acquire or merge.The value  from this method tells what is the cash necessary if a person wants to rebuild the business as it is presently.

Ratio Based Approach

It can be called as relative valuation method as well.In this method rather than directly valuing a company other companies of the same  sector,size and industry are taken and comparative study of various ratios are done to ascertain the value of a company.The ratios could be profit to equity ratio,profit to sales ratio,profit to EBIT  ratio etc.

Discounted Cash Flow

Discounted Cash Flow models are based on one of the most fundamental concept of corporate finance: The value of a company today is equal to the value of the future and uncertain cash flow converted in terms of today’s earnings.The value of the future cash flow is discounted at a certain justified rate which reflects the riskiness or uncertainty of those cash flows.Hence by projecting the likely returns that a business might give in the near future , a company can be valued.

It is unusual for a company  to just do one of these types of evaluation usually they do two or three of these types of valuation. DCF is the hardest and requires a lot of work as the future earnings have to be projected and have to be discounted back to its present value. Using the three prong approach a company can effectively value another company that it intends to invest or buy shares into that company.

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