Discover what business valuation is and its methods

Valuing a company is not the same as trading

Business valuation is an art that requires practice and an understanding of the various methods available. Remember that when we talk about valuing a company here, we're referring to a long-term investment strategy involving buying shares (this is not trading ).

The truth is that company valuation is part of what we call fundamental analysis, and it's not complicated. You just need to know how to do it. Here are some methods to get you started.

Article summary

Business valuation is essential to determining the fair price of shares.
There are several valuation methods, with EBITDA, EBIT and Free Cash Flow the most prominent.
Valuation multiples help us understand how long it will take to recover our investment.
Free Tools: Koyfin and company annual reports are essential for analysis.
Historical Comparison: It is important to know the historical average of the company and its sector to make an accurate valuation.

What is business valuation?

Business valuation is the process of determining a company's intrinsic value. It's a key financial tool that helps us understand a company's true worth, whether for selling, merging, or simply making strategic decisions (such as buying shares). This allows us to determine if the share price is fair, expensive, or cheap.

Assessment objectives

The objectives of business valuation are varied. Some of the most common include:

Selling the company: Knowing how much your company is worth is crucial if you are thinking of selling it.
Mergers and acquisitions: In these cases, it is important to know the value in order to negotiate better.
Attracting investors: A good valuation can attract potential investors.
Buying shares: Correctly valuing a company can present interesting opportunities to buy shares.

Valuation methods

There are several valuation methods, but we will focus on the most commonly used ones:

EV/EBITDA: This method relates the value of a company to its EBITDA. To calculate it, we divide the Enterprise Value (EV) by the annual EBITDA. A low multiple indicates a good investment opportunity.
EV/EBIT: Similar to the previous method, but uses EBIT. This method is also popular among analysts and can yield good results if applied correctly.
Price-to-Earnings Ratio (P/E): This is one of the best-known methods. It relates the share price to the company's net income. Although widely used, it is not always the best, as it does not consider the company's debt or cash balance.
EV/FCF (Free Cash Flow): This method is considered one of the most conservative, as it relates the value of the company to its free cash flow. It is a purer way to value a company, since it includes its financial position.

McDonald's numbers

Dejabo you can see a screenshot with McDonald's cash flow data (by the way, I recommend the movie The Founder about the history of McDonald's, it doesn't talk about finance but if you like companies and have an entrepreneurial spirit you will surely like it).

Practical example

Let's imagine we're interested in buying a McDonald's with a asking price of €10 million (the figures aren't up-to-date; they're just for illustrative purposes). To determine if this price is fair, we need to calculate the valuation multiples:

Sales: 5 million euros
EBITDA: 15 million euros
EBIT: 13 million euros
Net Profit: 900,000 euros
Free Cash Flow: 1 million euros

If the Enterprise Value is 9 million euros (10 million euros less 1 million in cash), we can calculate the multiples:

EV/EBITDA: 9 / 15 = 0.6
EV/EBIT: 9 / 13 = 0.69
PER: 10 / 0.9 = 11.11
EV/FCF: 9 / 1 = 9

These multiples tell us how many years it will take to recover our investment. For example, if we buy McDonald's using the EBITDA multiple, it would take 6 years to recover our investment, while with the Free Cash Flow multiple, it would take 9 years.

Valuation multiples: What are they?

Valuation multiples are tools that allow us to compare the value of a company with its financial performance.

These multiples, such as EBITDA or the P/E ratio, are fundamental in determining whether a stock is expensive or cheap. However, it's crucial to have a benchmark for making this assessment. These multiples are usually compared to those of similar companies to determine your company's value.

The importance of comparison

To determine if a multiple is expensive or cheap, we must compare it to the market average or to competitors in the same sector. For example, if a business has a multiple of 6 times EBITDA, we need to know if that is reasonable compared to the market average, which is usually around 10 times.

Key market data

Some reference data you should consider are:

Average sales growth: 8%.
Average ROI: 13%.
Cyclicity: Moderate.
Average net debt: 2 times.

Returning to the McDonald's example, let's assume it has 20% sales growth and a 25% ROI . If we compare these figures to the market average, we can conclude that McDonald's is a higher-quality, higher-growth business. This suggests that the multiples the market should be willing to pay are higher than average.

Investment opportunities

If we find a company that meets our growth and quality criteria and is trading at below-average multiples, we could be looking at an excellent investment opportunity. For example, if McDonald's is trading at 6 times EBITDA instead of 10, this represents a 40% discount to the market average multiple.

Risks to consider

It's important to keep in mind that even if a stock seems like a good opportunity, there's always a risk that the multiple will compress. This can happen if there are undisclosed problems within the company. For example, if we buy McDonald's at 10 times EBITDA but then discover that profits will fall by 40%, the multiple could adjust to 6 times, resulting in a significant loss.

Tools for analysis

To perform an effective analysis, you can use two key tools:

Koyfin: A free platform that offers a summary of financial metrics and allows access to companies' financial statements (Morningstar and TIKR are two interesting alternatives but most of the tools they offer are paid).
Annual reports: Accessing the company's annual reports is crucial for obtaining detailed information.

Recommended stock market courses for long-term investing:

PV SCHOOL OF FINANCE by Enrique Valdecantos: This is my favorite business valuation course. As I've already said, there are no secrets to business valuation, but if you want to accelerate your learning, this course is ideal.
The Art of Investing by Alejandro Estebaranzis an online investment course designed to teach people with little or no prior investment knowledge how to build a solid, long-term portfolio. It focuses on a value investing methodology, similar to that used by renowned investors like Warren Buffett and Peter Lynch.
INVESTING FROM SCRATCH: This course is very similar to Alejandro Estebaranz's; the difference lies in the instructor. Both options are highly recommended.

Example of fundamental analysis

Conclusion

Valuing stocks is an art that requires practice and knowledge. By using the right tools and understanding companies' financial statements, any investor can learn to value businesses effectively.

However, you should know that finding hidden gems in the market isn't so easy, much less predicting what will happen in the long run. Your analysis might be excellent, but long-term investing exposes you to a type of uncertainty that goes far beyond company financials. A lawsuit, a new competitor emerging, a product that the market doesn't welcome—all of that can happen, but your analysis didn't account for it.

I don't mean to say that valuing companies through their multiples is useless, but rather that you should be clear that it's not the answer to everything.

Norberto Viale( Trader and founder of Experiencia Topstep )

My name is Norberto. I've been investing and trading for over a decade. I'm also the author of the trading course Experiencia Topstep. If you want to learn how to invest and have any questions, feel free to contact me.