Experts—such as appraisers, industry brokers, or bankers—hardly ever discuss the method used to calculate a company’s value anymore. The income approach—or EBIT approach—in combination with the discounted cash flow(DCF) methodis standard practice. This is further underscored by the fact that even case law considers these to be the “correct” methods for determining a company’s value or the value of an equity interest.
To apply the income approach, two variables are required: sustainable earnings and the interest rate. The latter is calculated using the perpetual annuity formula, meaning that the income value equals sustainable earnings divided by the interest rate.
Even though this and all other formulas are clearly defined, there can be debate regarding which values to use for each variable. Since a purchase price must always be amortized from future earnings, there is a consensus that sustainable earnings must be a well-founded estimate of future earnings. This can be derived from the earnings of past years using various adjustment factors, which depend on the type of business. However, this is only possible if the income statements from recent years present a relatively consistent picture and if it can be assumed that this situation will not change in the coming years.
To look ahead, factors such as the market and dependence on key business leaders must be considered. If it is assumed that the data will change, projected financial statements must be prepared to determine the sustainable future earnings. Even if these are merely probability-based calculations, they are the only correct way to ultimately determine an objective enterprise value. In contrast to the method described above, there are significantly greater differences of opinion among experts when valuing companies with regard to the interest rate at which sustainable earnings should be discounted.
In its nearly 30 years of valuation work, Sattler & Partner has encountered interest rates ranging from 5 to 50 percent. Depending on the discount rate used, such varying interest rates can cause a company’s value to increase or decrease by a multiple.
Every calculation of a company’s value must stand up to market scrutiny. The value determined for the company should, at the very least, be achievable—or close to it—upon its sale. Valuation reports with company values that, in practice, can only be realized at half that amount make no sense. The client could have saved the money spent on the valuation. “A company is worth what a buyer is willing to pay for it.” A good valuation anticipates exactly this.
For these reasons, it is important to have a business valuation prepared by experienced professionals. The associated costs are usually more than offset by the sale price achieved.
