Business Valuation Methods in M&A Transactions

19 November 2024, Frankfurt am Main

A company is ultimately worth what a qualified buyer is prepared to pay. This simple principle challenges many conventional assumptions held by both sellers and buyers. It also provides the starting point for robust negotiation strategies supported by recognised business valuation methods, which have evolved significantly over time.

The capitalised earnings method

For many years, the capitalised earnings method, standardised in Germany through the IDW S1 valuation standard, was regarded as the benchmark for business valuation. The method is also recognised in legal disputes. It discounts expected future company earnings to the relevant valuation date and generally assumes that the business will continue indefinitely.

The simplified formula divides forecast annual earnings by a capitalisation rate. For example, annual earnings of €400,000 and a capitalisation rate of 5% produce a capitalised earnings value of €8 million. A lower rate results in a higher valuation, which can lead to unrealistically high figures in periods of very low interest rates. Rising interest rates may increase the method’s practical relevance, while adjustments for risk and inflation also affect the calculated value.

The multiples method

In response to the uncertainties of earnings-based valuation and prolonged low interest rates, the multiples method has become a widely used alternative. Rather than deriving value solely from financial theory, it uses observed transactions within an industry to establish a market-based valuation range. Multiples are typically applied to EBIT or EBITDA.

For example, EBIT of €250,000 multiplied by an industry multiple of 4 results in an enterprise value of €1 million. Selecting the appropriate multiple is crucial and requires market experience. Multiples for media companies, for instance, can vary materially depending on digital maturity and other quantitative and qualitative factors. Our current guide explains in more detail how EBIT multiples are used to value SMEs.

Market perceptions and common misconceptions

Exceptional multiples achieved in start-up exits or unusual transactions are frequently cited, but they are not representative of most company sales. The assumption that large corporations automatically pay higher prices is also often incorrect. Corporate buyers typically apply strict investment criteria and carefully assess the expected return on invested capital.

Preparing a company for sale

The most effective way to maximise value is to prepare well in advance, ideally two to three years before the intended sale. This creates time to assess the company accurately, address weaknesses, strengthen capabilities and reduce risks, ultimately supporting a higher purchase price.

Combining valuation methods with market evidence

Comparing capitalised earnings and market multiples while considering current buyer demand, financing conditions and transaction dynamics provides a realistic basis for valuing and successfully selling a company. A calculation establishes the negotiating range; a competitive and well-managed market process determines the achievable price.

Would you like an informed assessment of your company’s value? Arrange a confidential, no-obligation initial consultation with our M&A experts.