The Four Most Important Valuation Methods and How to Truly Understand Your Valuation
This is the fundamental question for every entrepreneur who wishes to sell their company or needs to determine its value – whether for a planned transaction, discussions with banks, or for clarification within the family: "How much is my company worth?" Unfortunately, there is no simple answer. There are several answers, depending on the method you use. In this article, we explain the four most important valuation methods so you can understand what your company is truly worth.
The Core Concept: Enterprise Value vs. Equity Value
Before we delve into the methods, we need to distinguish between two terms: Enterprise Value (also "Gross Value" or "Company Value") and Equity Value ("Net Value" or "Shareholder Value").
Enterprise Value (EV): The Gross Value
Enterprise Value is the theoretical value of the company as if it were debt-free. This is the "business itself" – without considering debt or cash in the bank. It is the value an investor would pay for the operating assets if they were to finance the business themselves.
Equity Value (EqV): The Net Value
Equity Value is what the shareholder ultimately receives. This is the Enterprise Value minus debt plus cash. In other words: This is the value attributable to equity.
The Equity Bridge: The Connecting Link
The relationship is simple:
Equity Value = Enterprise Value – Net Debt (± Working Capital Adjustment)
An example: A company has an Enterprise Value of 10 million Euros. It has 3 million Euros in debt (bank loans) and 500,000 Euros in cash in the bank. The net debt is 3 - 0.5 = 2.5 million Euros. The Equity Value is 10 - 2.5 = 7.5 million Euros. This is what the shareholder receives net.
Enterprise Value is the business. Equity Value is the money that goes into your pocket.
Valuation Method 1:
Net Asset Value
The first method is the oldest and least used in modern M&A: the Net Asset Value. This answers the "What would it cost to rebuild this company from scratch?" question.
How does it work?
You take all the company's assets (machinery, buildings, inventory, receivables), value them at today's market price, and add them up. Then you subtract all liabilities. That is the Net Asset Value. There are two variants:
Gross Asset Value: The sum of all assets at market prices (without subtracting liabilities).
Net Asset Value: The Gross Asset Value minus liabilities. This is what the shareholder receives net.
When is this used?
The Net Asset Value is a lower bound. No rational business should be sold below its Net Asset Value. If your company has a Net Asset Value of 5 million Euros, you should not sell for 3 million. But the Net Asset Value is rarely the correct valuation for an ongoing, profitable business. Why? Because it ignores profitability. A highly profitable company with old, cheap machinery might have a low Net Asset Value but a high Capitalized Earnings Value. The Net Asset Value is primarily used for companies with no or very limited operational activity (e.g., real estate management companies). For operational SMEs, it serves only as a lower bound, not as the primary valuation method.
Valuation Method 2:
Multiples Approach (Multiples)
This is the most commonly used method in practice. It is simple and fast, which is why it is popular. The procedure is: Take a financial multiple of the company and multiply it by a market multiple.
The Concept
Company Value = Key Figure × Multiple
A simple example: Your company has an EBITDA (Earnings Before Interest, Tax, Depreciation, Amortization) of 2 million Euros. The market multiple for companies in your industry is 8x EBITDA. Then your company value is 2 million × 8 = 16 million Euros.
Which Key Figures are Used?
The most common are:
EBITDA: Earnings Before Interest, Tax, Depreciation, Amortization. This is operating profit without financing effects and depreciation. This is the most popular metric for M&A.
EBIT: Earnings Before Interest and Tax. This is profit before financing and taxes, but after depreciation. Less commonly used, but important for capital-intensive companies.
Revenue: Simply total sales. Used for companies with very different profitability. Example: Banks are often valued by revenue.
Net Income (PAT): Net profit after taxes. This is at the bottom of the P&L and is less frequently used because it is volatile.
Where do the Multiples Come From?
The multiples come from two sources:
Market Multiples: These are the multiples of publicly listed companies in your industry. If you have an engineering company, look at what EBITDA multiple publicly listed engineering companies are valued at on the stock exchange. These are current market data.
Transaction Multiples: These are multiples from comparable M&A transactions in the past. A typical example would be: "In 2023, an engineering company of comparable size was sold at a multiple of 7x EBITDA." Such transaction multiples are often more meaningful in practice than publicly listed comparables, as they reflect actual purchase prices. However, access to this data is limited. Corresponding information is regularly published in trade journals, databases, and M&A reports, but is often only available in aggregated form or for a fee.
Trailing vs. Forward Multiples
An important distinction: Trailing Multiple is based on earnings already achieved. Forward Multiple is based on future expected earnings. Example: If your EBITDA in 2023 was 2 million (Trailing) and you expect 2.2 million in 2024 (Forward), then the valuation can be different, depending on whether you use the 2023 or 2024 multiple.
Typical EBITDA Multiples by Industry and Size
These are indicative values; they vary depending on the economic cycle and industry:
Small Companies (EBITDA up to 1 million Euros): 4-6x EBITDA
Medium Companies (EBITDA 1-10 million Euros): 6-10x EBITDA
Large Companies (EBITDA over 10 million Euros): 8-12x EBITDA
Tech/SaaS Companies: 10-20x EBITDA (or even higher if high growth rates)
Crafts/Services: 4-7x EBITDA
EBITDA multiples are the backbone of modern M&A valuation. They are simple, but often underestimate the complexity of the business.
Valuation Method 3:
Capitalized Earnings Method (IDW S1)
The Capitalized Earnings Method is a method that looks at future profits and discounts them to today. It is theoretically cleaner than multiples, but practically more complex and susceptible to manipulation.
The Concept
The idea is simple: A company is worth as much as the present value of its future profits. If you expect the company to make 1 million Euros profit per year for the next 5 years, then you discount these profits to today and add them up.
IDW S1: The Standard in Germany
In Germany, the standard for the Capitalized Earnings Method is "IDW S1" – this is a standard from the Institute of Public Auditors in Germany (IDW). IDW S1 states: Take the "normalized" profits (i.e., the average, adjusted profits), project them 5-10 years into the future, and discount them with a "capitalization rate" (a discount rate that takes risk into account).
Capitalization Rate (Discount Rate)
The capitalization rate is key. It is a rate that reflects the risk of the company. The riskier the company, the higher the rate, the lower the valuation. For German SMEs, the capitalization rate typically ranges between 8-15%, depending on the risk.
The Problem with Capitalized Earnings
The Capitalized Earnings Method is susceptible to manipulation. Why? Because you have to project profits. And the seller has a strong incentive to project profits upwards. "Well, the next 5 years will be fantastic, we've won a big client..." Suddenly the valuation is 30% higher. This is a problem that arises in practice.
Valuation Method 4:
DCF Method (Discounted Cash Flow)
The DCF method is theoretically the cleanest and most preferred method by Warren Buffett and other investors. But it is also the most complex.
The Concept
The idea is: A company is worth as much as the Free Cash Flows it can generate in the future, discounted to today. This is "Cash" – not profits, not revenues, but cash.
Free Cash Flow (FCF)
Free Cash Flow is the cash generated by the company after operating costs and reinvestments have been paid. It is the money that is "free" – that you can take out of the company.
WACC: Weighted Average Cost of Capital
The WACC is the discount rate. It is a weighted average of the cost of equity and debt. This is complicated to calculate, but it reflects the "risk" of the company. The higher the WACC, the higher the risk, the lower the valuation.
Terminal Value
An important part of the DCF method is the "Terminal Value" – the value of the company at the end of the projection period (e.g., year 10). This often accounts for 50-70% of the total valuation, which means that the Terminal Value assumption is critical. A small error in the Terminal Value assumption can change the entire valuation by 20%.
Why Does Buffett Love the DCF Method?
Buffett uses the DCF method because it answers the question that matters to him: "How much cash can I take out of this company in the long term?" This is pragmatic and focuses on what is important. But the method is susceptible to errors in assumptions, especially for the Terminal Value.
Normalization of Earnings: The Critical Detail
No matter which method you use, there is a critical detail: the normalization of earnings. This means you have to "clean up" historical earnings to see how much the business normally makes.
What Needs to Be Normalized?
Owner's salary: If the seller takes a very high salary that is not market-appropriate, this must be corrected. A buyer would pay a more reasonable managing director.
One-off items: Sale of real estate, restructuring costs, insurance payouts. These should be excluded from earnings.
Related-party transactions: If the seller "rents" to themselves (e.g., a building that the seller privately owns and rents to the company), the rent must be normalized to market rates.
Extraordinary losses: Product rejects, legal disputes, theft. These should be excluded if they are not systemic.
Practical Considerations: The Gaps and Discounts
Theory says: Calculate the Enterprise Value using one method. But practice is full of adjustments and discounts.
Size Discount (Lack of Marketability Discount)
A problem with smaller companies: They are less "fungible" – less interchangeable in the market. A buyer knows that it is difficult to find another similar buyer. Therefore, there is often a discount for size. A very small company could have a 20-30% discount because it is simply riskier.
Key Person Dependency
If the company is highly dependent on one person (e.g., the founder with a client relationship), then there is a discount. A buyer pays less if there is a risk that the key person will leave. A 20-30% discount is not uncommon.
Synergies
On the other hand: A buyer might pay a premium if they see synergies. Example: A buyer with a large distribution network can make the company more profitable than it is today. The buyer could pay 15-25% extra because they see where the synergies are.
What it's worth and what someone is willing to pay are two different things. The true purchase price is somewhere in between.
A Practical Example:
The Metal Processing Company
Let's go through a real example. A metal processing company, founded 20 years ago, has the following financials:
Revenue: 10 million Euros
EBITDA: 2 million Euros (20% EBITDA margin)
Debt: 1 million Euros
Cash: 200,000 Euros
Net Assets (Net Asset Value): 2.5 million Euros
Valuation by Different Methods:
Multiples Method: 2 million EBITDA × 7x = 14 million Enterprise Value
Equity Value: 14 - (1 - 0.2) = 14 - 0.8 = 13.2 million Euros
Capitalized Earnings Method: Normalized earnings 1.4 million Euros/year, capitalization rate 10%, approx. 12-14 million Enterprise Value
DCF Method: FCF 1.6 million Euros/year, WACC 9%, Terminal Growth 3%, approx. 15-18 million Enterprise Value
Summary: The valuation ranges between 12-18 million Euros Enterprise Value, depending on the method and assumptions. The Equity Value (what the seller receives) would be approx. 11-17 million Euros after debt deduction. This is a large range, but it shows that different methods yield different results.
An intelligent seller would obtain several valuations (an investment banker, an independent appraiser) and see where the consensus valuation lies. Then they can negotiate with potential buyers.
The Critical Point: What is the Difference Between "Worth" and "Selling Price"?
This is the most important insight: What the company is "worth" and what someone is "willing to pay" are two different things. The purchase price is somewhere in between, depending on negotiation, market conditions, and synergies.
The valuation is the foundation. But the selling price is determined by supply and demand. If many buyers are interested, the price increases. If few are interested, the price decreases. A sound valuation protects you from undervaluation, but it does not guarantee the best price.
Practical Tips: How to Understand Your Valuation
1. Obtain multiple valuations: A tax advisor/auditor, an investment banker, perhaps an academic appraiser. See where the consensus is.
2. Understand the assumptions: Every valuation is based on assumptions (EBITDA multiple, growth rate, discount rate). Ask about these assumptions and check if they make sense.
3. Normalization is critical: If the appraiser does not normalize your earnings, you will see surprising differences compared to buyer valuations.
4. EBITDA is the Lingua Franca: In practice, buyers talk about EBITDA multiples. Understand what EBITDA multiple companies in your industry are sold for.
5. Don't anchor the price too early: Your valuation is important, but don't reveal your asking price too early in the negotiation process. Let the buyer do their own valuation.
6. Synergies are Gold: If buyers see synergies, they pay more. Make it clear where the synergies are (sales, technology, production).
Conclusion: The Right Valuation is the Foundation
Company valuation is not exact – it's more art than science. But a good valuation provides you with a foundation for negotiations and protects you from undervaluation. The most important points:
1. Understand Enterprise Value and Equity Value
2. Know the four methods and understand their strengths/weaknesses
3. Normalize earnings – this is critical for realistic valuations
4. Obtain multiple valuations and understand the assumptions
5. Know that valuation is the foundation, but the purchase price depends on negotiation
If you want to sell your company, invest in a sound valuation. It's not expensive compared to what you're selling. A good valuation can bring you 10-20% more in purchase price. This is the best ROI investment you can make.
