Determining the enterprise value

The classical school of thought – which is advocated by many European auditors and tax advisors – bases the determination of a company’s value on the figures in its balance sheet..

Expect that during the negotiation a reputable auditor will explain the company’s balance sheet items to you and tell you that the sum of the individual assets – such as buildings, machinery, fleet, patents, goods, receivables, etc. – minus the debts equals the fair purchase price for the company.

This is not the case; do not fall for it.

The fundamental difference between the two schools of thought is this: the Anglo-American one assumes that the company will continue to operate and generate cash flows in the future.

The classical school of thought, on the other hand, tacitly assumes that the assets (buildings, machines, stock goods, etc.) are sold individually, i.e. that the company is broken up and the assets only bring in proceeds once.

The Anglo-American school of thought, according to which international investment banks work, assumes that a company is a machine that generates cash flow on a permanent basis. It is irrelevant how expensive the assets are that the company needs to generate cash flow. What matters is the amount of annual cash flow.

The future cash flows are planned and discounted, resulting in a present value. The calculation method is exactly the same as for a bond, where the future interest income and the current interest rate make up today’s bond price.

You, as buyer of a company, most likely want to continue to operate the company and collect future profits. Then the Anglo-American way of thinking is the relevant one for you.

And consequently, you should use the future cash flows for your valuation.

The enterprise value determined on the basis of discounted future cash flows differs significantly from the value determined on the basis of balance sheet figures.