Knowing the value of a company is essential for business owners as well as potential investors. Therefore company valuation is critical for your startup.
As businesses grow, owners need to know how much the business is worth so that they can raise capital or borrow money accordingly.
If you are a business owner and want to sell your business or a part of it, it is imperative that you know the value of your business.
For an investor, company valuation is a critical factor when deciding whether to invest in a business or not and also to calculate the potential return on investment.
What is company valuation?
Before diving into the company valuation process, let us understand what it means.
Company valuation is used to determine the economic value of the entire business or company or a part of it. It is used to arrive at the fair value of a business.
It can also be described as how much it would cost to purchase the business or the selling price of the business.
How is a company’s value calculated?
Company valuation for public companies is relatively simple, and it can be calculated by multiplying the share value with the total number of outstanding shares. This is also known as market capitalization.
For example, Amazon’s share value for the quarter ending March 2020 was $1949.72, and the number of outstanding shares was 499 million, so the market capitalization of Amazon for the quarter ending March 2020 was $972,910 million ($1949.72*499 mil).
Of course, the company’s valuation has crossed the one trillion mark and stands at $ 1,524,778 million on 6/7/20.
Things get a little tricky when trying to value private companies as these companies do not report their finances publically, and they are not listed on the stock exchange.
Different methods can be used for the valuation of private companies.
What are the methods used for company valuation?
Before starting the valuation process, it is crucial to understand what needs to be valued. Are you looking at valuing the entire business or a part of it?
It is also important to know the purpose of the valuation. Are you looking at selling or buying a business, liquidating it, or are you looking at a valuation for tax purposes?
These answers determine the approach that you use.
Here are 3 different methods used for company valuation:
1. Comparable Company Analysis Method (CCA)
A common and straightforward way to assess a privately owned business’s value is the relative company analysis.
This technique values a company by comparing the target company’s valuation multiples to those of its peers within the industry.
The company that you choose for comparison should be from the same industry, and it should have a similar size and growth rate; a direct competitor would be the right choice for this purpose.
The idea behind comparing companies that have similar characteristics is that these companies should trade at similar multiples, assuming all other things are equal.
Various companies that have similar businesses are identified and the averages of their valuations or multiples are used to understand how the target company fits within the industry.
Valuation measures used include enterprise value to sales (EV/S), price to the sale (P/S), price to book (P/B), price to earnings (P/E) earnings before interest tax depreciation, and amortization (EBITDA).
Ratios of similar businesses are used to find out if the company is overvalued or undervalued. The right firm, a suitable multiple, and the right variable must be used for comparison.
Valuations based on this method are easy to calculate using widely available data. This method is less reliable on the downside, and it may be difficult to find an appropriate comparable, especially for a small business.
2. Discounted Cash Flow Method (DCF)
Discounted cash flow method is a way of estimating how much an asset is worth today based on the value of money it can make in the future.
DCF technique tells you how much you should spend on an investment today to get the desired returns in the future.
This method can be used to calculate the value of a business, a stock, a bond, and so on.
When using this method for valuing a company, the discounted cash flow of similar companies in the industry is calculated and then applied to the target company.
Discounted cash flow analysis is based on the time value of money principle.
This principle assumes (and all of us are aware) that money is worth more today than it would be in the future.
$1000 is worth more today than what it would be worth after a year. This is due to various reasons like inflation, opportunity cost, and uncertainty of receiving money in the future.
Assuming $1000 is invested today @ 10% for a year, it would be worth $1100 a year later.
Using this method, all future cash flows are discounted to arrive at their present values by using a discount rate.
DCF= CF1/(1+r)1+ CF2/(1+r)2+……………….. CFn/(1+r)n
DCF analysis is done based on the following elements:
How much can be earned by investing in another asset/company with equal risk.
This is represented by “r” in the equation. For valuing a business, the discount rate is the Weighted Average Cost of Capital (WACC).
WACC is used because it represents the required rate of return that investors expect when investing in the company.
The period for which the analysis is done, represented by “n.”
Projected cash flow
Cash flow expected to occur annually, represented by “CF.”
The DCF method is extraordinarily detailed, and it determines the intrinsic value of a business.
However, there are some drawbacks also when using this method; estimating the WACC could be tight, and a large number of assumptions make it complex and prone to errors.
3. Asset-Based Valuation Method
Asset-based valuation is another approach to company valuation. This approach focuses on the balance sheet of the company.
It involves totaling the assets held by the business and subtracting liabilities from it.
The adjusted net asset method is one of the techniques used when calculating the value of the business using this approach.
The difference between the fair market value of the assets and the fair market value of all the liabilities is the company value.
ABV = Fair value of the company’s total assets – its total liabilities
It is essential to recognize that the current value of assets will be different from the original cost or the cost at which it was acquired.
So a piece of land repurchased at $50,000 15 years ago would not be worth the same today.
It needs to be valued at its current value (fair value), which could be $2 million.
However, when valuing machinery, you would have to account for the depreciation and reduce the value of the asset accordingly.
Liabilities are generally stated at the fair market value, so reworking on their values is required.
However, when valuing machinery, you would have to account for the depreciation and reduce the asset’s value accordingly.
Being relatively simple to calculate and easy availability of data are the main advantages of this method.
Disadvantages include difficulty in valuing intangible assets and not factoring in the company’s future earnings.
As discussed, the valuation process will always depend on the reason for valuation.
There is no right or wrong method, you can pick one based on your judgement and requirements. You can also use a combination of the three methods.
Factors like a good business plan, market conditions, staff and management, growth prospects, etc. are some intangible factors that may also influence the business valuation.
If you are looking to calculate the revenue for your startup, you can read about it in our article.