In valuing a business, the most important component is working out the firm's intrinsic value (underlying value). A firm's intrinsic value refers to its earning power over its life time.
Valuing a business is anything but straightforward and will always be an estimate, given that there is no precise way of knowing what a business is intrinsically worth. However, here are some starting points which can help you work out what a business is really worth.
1) Calculate Free Cash Flow: To calculate free cash flow, use the following formula:
Net Income + Depreciation & Amortization – Maintenance capex
Using this formula allows you to work out how much free cash flow can be distributed to owners throughout the life of the business.
2) The Economics of the Business & Sector: Is the business able to earn high returns on equity and reinvest surplus capital into the business? What does the firm earn on its assets? How much debt does business require and is it poised to profit from favourable developments in the sector it operates? These are all questions which should be asked to calculate growth/earning potential.
3) What is the firm's competitive advantage: Having an entrenched competitive advantage can allow a firm to ensure its continued existence and fight off competition. This is crucial for the long-term survival of any business. You need to make sure that a business will survive into the future and if the cash flow it generates will be sustainable.
4) The ability of the management to create value: Excellent leadership is crucial to the ongoing success of any business. This includes a firm's ability to innovate and become an industry leader. Stagnant management may cause a firm's competitive advantage to be eroded over time due to a lack of attention.
5) The Impact of Inflation/taxes: How will the business be impacted from rising prices? Will it be able to pass on higher costs to consumers or does it operate in a fiercely competitive sector where a price war is likely to take place if there are substantial cost increases. Additionally, does the firm operate in a sector which may face higher taxes in the future (i.e. tobacco or fast food sectors) or is it favourably viewed, meaning that it may be able to receive significant government benefits (renewable energy).
Learning to value businesses takes time and practice. As an investor you should spend as much time as possible learning to value different businesses, as this will be most helpful for you to get a feel of what each individual business is really worth. Over time, you will begin to gain a more precise understanding with regards to precisely what everything is worth.
