Business Valuation For Beginners
WHY IS A VALUATION USEFUL?
A valuation can help you to determine the market value of your company. It is very common to use a range of different measures to understand the economic value of a business.
A company valuation is useful for entrepreneurs and business owners looking to fundraise or buy/sell a company.
On the other side, in order for an investor to gauge how much they are willing to invest in any business, no matter the stage, they would need to know what the market value is of the business they are considering investing in.
There are quite a few variables that come into play when considering business valuation and we unpack these with the view in mind to shed a bit more light on the subject.
WHEN DO I NEED A VALUATION?
It is important to note that when you evaluate your company or decide to get a third party valuation, it does not necessarily mean that the company’s value is now set in stone and the investor/buyer needs to invest at this value.
Usually, institutional investors will inform you under what conditions they will invest and what valuation they have in mind.
However, if you want to make sure that you understand approximately how much your company is worth without selling yourself undervalue or without expecting outrageously high numbers, it’s useful to get an objective third party valuation.
HOW TO VALUE MY COMPANY?
Sure, you want to minimise the number of shares you will eventually give to investors, but you don’t want to scare them off either. Above all, being reasonable and realistic is the key when it comes to valuing your own company effectively.
The use of several methods is considered best practice in company valuation, as looking at the business from different perspectives results in a more comprehensive and reliable view.
Let’s jump into some theories behind asset valuation.
The idea that sits at the centre of valuation is the concept of Fair Value:
This seemingly simple sentence pinpoints some basic key principles:
- any valuation is a given that has sense at the moment in which it is created. After that moment, be it days, hours or minutes (seconds and microseconds in publicly traded companies) the business may have a totally different value;
- the ideal transaction is carried out by rational actors in an open marketplace;
- and there are no special circumstances in which the transaction is carried out (that’s why when a company acquires a competitor because of a strategic advantage it may benefit from, it will normally pay a premium on top of the market value).
We could use several techniques to create a valuation that may reasonably close in towards the effective value that the market is willing to pay.
In broader terms, valuation theory recognises four distinct approaches in the valuation of shares and businesses. These are:
- the Cost Approach;
- the Asset-Based Approach;
- the Market Approach (direct market comparison), and,
- the Income Approach;
The Cost Approach is a last resort approach.
When other methods are not applicable, this approach bases the valuation on the cost to create or replace the asset with a similar one, on the premise that a purchaser would not pay more for a business than the cost to obtain one of equal usefulness.
This method is frequently used in valuing investment companies or capital intensive firms.
The asset-based approach measures the value of a business by referencing the value of its individual assets and liabilities.
This is the road that is usually taken in Real Estate, where properties represent the vast majority, if not the totality, of the company value.
The market approach provides an indication of value by gauging the company with comparable businesses for which some basic indicators are available.
Here is where you start hearing the term “multiple”. The market multiple method focuses on comparing the subject asset to similar, publicly-traded, companies and assets.
In this method, valuation multiples are derived from historic and operating data of comparable businesses.
The income approach has a number of variants, but essentially this approach is based on the income that an asset is likely to generate over its remaining useful life. In the case of a business, the earnings that it will generate in the future.
This approach includes methods like:
- The Discounted Cash Flow (DCF)
- The VC Method