Business Valuation Blog | Understanding Buying / Selling a Company

How do you determine the value of a business using ratios?

Posted by Business Valuation Specialists LLC on Aug 5, 2015 11:00:00 AM


Is it a good investment or a bad investment? Are you getting the most that you can when you sell your business? Business valuations can help facilitate the sale of a business and can also be useful in a number of other situations. So, how do you determine the value of a business? Business valuation specialists rely on several different ratios as at least part of their analysis when they are asked to establish the worth of a company. Valuation ratios provide investors with insight into whether a company is priced too high, is reasonably priced, or is being offered at an attractive, below-market value price. While financial ratios are not the end-all to an accurate valuation of a company, they are a strong tool.

Ratios are relationships between two or more variables. They are useful in a business appraisal because they use actual numbers to measure such metrics as sales, earnings, and cash flow. Ratios also have their limitations. They can not measure valuable intangible assets like goodwill or a large and loyal customer base. In order to get the most accurate company valuation, business appraisals typically include more than one type of ratio. Listed below are five of the most common financial ratios used to determine the value of a business. 

Price-to-Book Value

To arrive at the price-to-book value ratio, you divide the stock price per share by the book value per share. Book value is a conservative measure of the company's value based on net assets (assets-liabilities). When considering a purchase, the investor can get a sense of value by noting the multiple (selling at 10-times book value) or discount (selling at less than book value) of the sale price. Book value records assets at their historical cost and may not reflect the current value. It does not account for such variables as goodwill and growth, which can add value to a business. A company valuation that relies only on the price-to book value ratio can dramatically underestimate the true value of a company. 


This ratio compares the price-per-share to the earnings per share. It is commonly known as a P/E ratio and can be an indication of whether a company's stock is cheap, priced correctly, or priced optimistically. When a company's P/E ratio is high, it can mean that it is overpriced, or it can mean that it is selling at a high multiple based on strong expected growth. By the same token, a low P/E ratio can mean a company is undervalued or has limited growth potential. As a precaution, investors should be aware that earnings can be manipulated by management and future earnings may be based on subjective assumptions. Either, or both of these factors can lead to a less accurate P/E ratio and the wrong valuation of a company. 

Price-to-Cash Flow

This ratio compares the price of a company's stock to the cash flow generated by the company. Many consider it to be a more reliable method of determining value than a P/E ratio. Unlike earnings which can be manipulated by non-cash items such as depreciation and tax planning, the price-to-cash flow ratio gives a more accurate picture of a company's financial health.   


Called the PEG ratio, this ratio is more robust than a P/E ratio because it factors growth into the equation. Investors value growth and that can add to the value of a company. A PEG ratio of 1.0 indicates a company is fairly priced. A PEG ratio above 1.0 may indicate that a company is overpriced. A PEG ratio below 1.0 may indicate a company is a bargain. 


This ratio will tell you the price of a company's stock as compared to annual sales. Like cash flow, sales data is not easily manipulated. The higher the price-to-sales ratio is, the more investors value the company. 

Valuation ratios are not perfect. How do you determine the value of a business that benefits from the goodwill it established by being a socially and environmentally conscious company? How do you determine the value of a business that is highly dependent on one or two key people?

Each business is different. For small companies, ratios may not be an effective method to understand and value the operations becuase of size differences between public companies where this information is much more available.  If you want an accurate business valuation, get a business appraisal from a professional and experienced business valuation specialist.


Topics: business value, value of a business