Company Valuation Methods: Earnings, Assets and Dividend Approaches

It is important to understand that valuing companies is both a science and an art. No two valuers will come to the exact same judgement. Consequently, we often use multiple methods to come to a more rounded conclusion, considering different approaches. Each approach comes with its own benefits and risks, and its appropriateness will depend on the purpose of the valuation.

Naturally, valuations are hugely important, and failing to come to a reasonable and well-supported conclusion can cost you both time and money in liaising with HMRC. Professional advice can help avoid these consequences, as well as providing you with reassurance.

Which company valuation method should be used?

There are several ways to value a company, and the most appropriate method will depend on the nature of the business and the purpose of the valuation.

The main approaches covered in this article are:

• Earnings based valuation, which considers a company’s ability to generate future profits.
• Cost approach, also known as the net asset basis of valuation.
• Dividend yield approach, which values shares based on dividend income.

Each approach has its own benefits and risks, and in many cases more than one method may be considered before reaching a conclusion. In addition, where a minority shareholding is being sold, it will be necessary to consider the discount that should be applied to the valuation of that holding.

Earnings based valuation

This is the most common method we use at Stratos for valuing trading companies. It concludes the value of the company based on its potential to generate profits in the future and determines what a hypothetical buyer and seller would be willing to buy or sell the company for. This is calculated by determining a company’s future maintainable earnings and then applying an earnings multiple to ascertain the company’s value.

To come to the above conclusion, we use the company’s EBITDA: its earnings before interest, tax, depreciation and amortisation. Adjustments are then made regarding any non-market value transactions, such as overinflated or underinflated directors’ remuneration. This may also include non-recurring expenditure, such as large legal costs.

Once the future maintainable earnings have been established, an earnings multiple is applied to reach the value of the shares. This is determined by referring to the sale values of companies in the same field to identify what the market is willing to pay for the company’s earnings, with an appropriate discount applied.

This method is most appropriate for growing companies that are expected to continue in business. This is notably because the earnings basis accounts for the trajectory of the company, based on its previous years’ income. However, this method is not appropriate for loss-making companies or companies entering liquidation, as they will have no earnings.

Cost approach, or net asset valuation

Otherwise known as a net asset basis of valuation, the cost approach answers one question: what would it cost to recreate the business from nothing?

In practice, this is calculated by adding up the underlying market values of the company’s assets and subtracting its liabilities on its balance sheet. This can be referred to as its “book value”.

This approach is rather simple as a result and is used mainly when valuing the going-concern net asset value of a company and on break-up or liquidation. However, in practice, a risk arises when arriving at the valuation, as assets may need adjusting to calculate their true market value.

For example, if a company owns a building, the asset on the balance sheet is likely to show what the company paid for the property. This may not be the true market value of the property, particularly if it was bought a number of years ago. Hence, a professional opinion is recommended to make these adjustments and ensure that no under- or over-valuation occurs.

The cost approach is very suitable for asset-heavy businesses, as it is objective and transparent, with limited scope for subjective opinion. By contrast, it is less suited to profitable trading businesses, as it does not account for off-balance sheet assets, such as the trajectory of the firm and its future earning potential.

Dividend yield approach

The dividend yield, or income, approach values shares based on the income that is received by investors through dividends. The basis of the method is simple: a share is worth what its future dividends are worth to you today.

The approach uses a formula to analyse how much a company pays in dividends each year to its shareholders, and whether those payments are likely to be stable or grow over time.

This approach is more suited to stable companies that regularly produce dividend payments, which are the key part of the investors’ returns. However, newer companies that see fluctuations in returns will be less suited to this approach.

This is because the approach relies on many assumptions, namely that the company produces constant dividend growth. If this is not the case, then the approach will not produce a suitable value of the company.

Discounts for restrictions on minority shareholdings

Within any approach to valuation, the result represents the value of 100% of the shareholding in the company. However, if the valuation is being carried out to ascertain the value of a minority shareholding, say 25%, then adjustments have to be made.

This is because buying a minority shareholding does not have the same benefits as buying 100% of the shareholding. For example, with only 25%, you do not have control over decision-making compared to a shareholder who owns the remaining 75% of the shares. Therefore, a discount must be applied to the value of the minority shareholding.

The level of the discount varies depending on a wide range of factors, namely the size of the interest, the spread of other interests, and the pattern of dividend payments.

After these discounts have been accounted for, the result is the value of the shares.

Summary: Choosing the right valuation method

There is no “correct” valuation technique. Every method has its benefits, which vary depending on the nature of the valuation.

What valuation does require is knowledge and analysis of the business being valued, the market, and the broader economic background in order to conclude a reasonable valuation. Hence, it is highly recommended that valuations are carried out by those with the relevant knowledge and experience.

If you require a valuation of your business, or need support with a valuation for HMRC, investment, employee share schemes or succession planning, our team can help you navigate the way. Please get in touch for an initial discussion.

FAQs: Company valuation methods

What is the most common method for valuing a trading company?

The earnings based valuation method is commonly used for trading companies. It considers the company’s future maintainable earnings and applies an earnings multiple to reach a value.

When is the cost approach used?

The cost approach, also known as the net asset basis of valuation, is mainly used when valuing asset-heavy companies or companies on a break-up or liquidation basis.

What is the dividend yield approach?

The dividend yield approach values shares based on the income investors receive through dividends, and whether those dividends are likely to remain stable or grow over time.

Why are discounts applied to minority shareholdings?

Discounts may be applied because a minority shareholding does not carry the same control or benefits as owning 100% of the shares.

Why should a professional valuation be obtained?

A professional valuation can help ensure that the conclusion is reasonable, well-supported and appropriate for the purpose of the valuation, including where HMRC may review it.