Examples of Business Valuations

by Leslie McClintock
Unrealized gains represent price increases in securities you currently own.

Unrealized gains represent price increases in securities you currently own.

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People buy and sell businesses -- or stocks in businesses -- for two reasons: an expectation of future dividends or an anticipation that the stock will eventually appreciate in value, even if no dividends are paid. While not every stock will be a good investment, any company can be a bad choice if you pay too much to own it. Before you buy a company -- whether you buy it whole or just a few shares' worth -- you should understand how businesses are valued to help ensure you are making a solid investment.


Business is all about earnings. In the long run, if you don't have earnings, or at least a reasonable path to profitability, there's not much point in maintaining the business. The price-to-earnings ratio is a measure of the business's profitability relative to its cost. Simply divide the share price by the earnings per share. This gives you an idea of what it costs you to "buy" a dollar of current earnings per year. If a stock selling for $10 has earnings of $1 per share, the price-to-earnings ratio, or P/E, is 10. It costs you $10 to buy $1 of earnings. Low P/Es are good for investors, all else being equal.

Book Value

The book value of a business is whatever would be left over if the owners decided to liquidate the entire business immediately, ceasing operations and selling off the assets to the highest bidder. The proceeds would be used to pay off all the business's creditors, including vendors, employees and bondholders. If the number is positive, and there is cash left over at the end of the process, a business has a positive net worth.

Price-to-Book Value

The price-to-book value ratio is what you would pay for the business to get the book value of the business. The book value is sometimes a useful "floor" for the valuation of a business. If a business has a share price that is less than it's book value per share, shareholders have a "margin of safety," in that if the worst happened and the business had to shut down tomorrow, they would still eventually be able to recoup their investment through the sale of assets.

Dividend Discount Model

The dividend discount model relies on an estimate of future cash flows from the company that would be available to pay dividends to owners. The theory is that the value of a business is equal to the expected future stream of dividends discounted back to the present time, at prevailing rates of interest. A dividend being paid tomorrow would be counted as a greater value than a dividend payable in a year. Similar calculations can be made with free cash flow, if the company is not currently issuing dividends. This model disregards assets on hand, since the book value of a company only becomes relevant in the event of a liquidation. Book value is an indication of the liquidation value of a company, while the dividend discount model values the company as a going concern.

Resources (1)

  • "Security Analysis"; Benjamin Graham and David Dodd; 1934

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