Business Valuation: Calculating the Value of a Company

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  • 0:04 Definition of Company Value
  • 2:43 Investment Risks
  • 3:19 How Long to Hold
  • 3:45 Your Portfolio
  • 4:41 Lesson Summary
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Lesson Transcript
Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

This lesson shows how you can evaluate a company to see if it is worth investing in. You'll learn about the three different ways you can determine the value of a company.

Definition of Company Value

Before you go ahead and make an investment in a company, you'll want to determine its value to see if it will be worth your time and money to invest in the company. We define company value as the worth of a business. You can think of company value as how much it would cost to purchase the business, or a company's selling price.

There are three main ways that businesses are valued today. They can be valued using the asset approach, the market approach, or the income approach.

The asset approach calculates all the assets and liabilities of a company in its valuation. The company value then is the assets minus the liabilities. For example, if a company has $4 million in assets and $2 million in liabilities, the company value here is $4 million - $2 million = $2 million.

The market approach values a business according to the stock market. This method looks at what other similar companies are worth on the stock market. To calculate the company value using the market approach, you take the stock market per share of the similar company and multiply it by the total number of shares the similar company has.

For example, a computer company is similar to other computer companies on the stock market that are currently worth $10 to $13 per share with each company having 10,000 shares. Multiplying the cost per share by the total number of shares, we get two different values. We get $10 * 10,000 = $100,000 and $13 * 10,000 = $130,000. So the company has a value between $100,000 and $130,000.

The third approach is the income approach. One way to use the income approach is to divide the annual earnings by the capitalization rate. The capitalization rate is the value that is used to convert a company's annual earnings to its company value. You divide a company's annual earnings by the capitalization rate to arrive at the company value. So, if the capitalization rate is 1/3 and a company has an annual earning of $150,000, then its company value is $150,000 / (1/3) = $450,000.

You can use any of these methods, although if you're investing in the stock market, it will be a good idea to use the market approach so you know the selling price of similar companies on the stock market. Knowing the price of similar companies will tell you if the price of your company is inflated or not. If your company's price is much higher than similar companies, then the company's price may be temporarily inflated for some reason. Investing in such a company may mean you'll lose money in the future when the stock price drops down to the price of the similar companies on the stock market.

Investment Risks

After you've calculated a company's value, you also need to consider how risky it will be to invest in the company. Things you'll need to consider are how long the company has been in business, market trends, and consumer trends.

If it's a new business, the risk is higher since you don't know how the company will perform. A business that has had a record of growth will have a lower risk. The riskier the investment, the higher the likelihood that you will lose money. Also, if the market trend is a decrease in stock prices, then investing in the company may be a higher risk. If the market trend is an increase in stock prices, then investing in the company is a lower risk.

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