The different methods for valuation of your business
Valuing a business is anything but a precise science. A company is ultimately worth what someone is willing to pay. Even that will vary over time depending on liquidity availability and prospects for the future as viewed by potential buyers. Business valuations have been rising over the last 10 to 15 years, for example, US businesses under $1bn in revenue have increased sales prices by nearly 50% over the previous 10 years. European businesses have also increased their achieved prices by a more modest 10 to 20%. This reﬂects corporate and private equity’s ‘dry powder’ or cash waiting to be spent and the ease with which funds can be raised. In both cases, this has increased substantially over the period discussed.
Potential buyers’ value depends on what you can do with a business to increase cash production. This may involve merging with current operations to create economies of scope and scale, investing in new products, accessing new market segments, or using technology or patents acquired with the business. Hence the valuation depends on assumptions about the exploitation of future opportunities.
In that context, Buyers often apply several valuation techniques to help capture the business’s fair market value. Such strategies revolve around four main approaches; the intrinsic value approach, the market approach, the cost approach, and the asset-based approach.
- Intrinsic Value Approach (Discounted Cash Flow Analysis “DCF”): This is the most thorough way to calculate the value of a company. When assessing the value of a potential target, virtually all potential acquirers build a discounted future cash ﬂow model of the business, which evaluates and makes assumptions about cash needs and production in coming years. This will reﬂect future investments, cost savings, increased sales, potential disposal value, and initial purchase consideration.
A DCF analysis is performed by building a financial model in Excel and requires extensive detail and analysis. It is the most detailed of the three approaches and requires the most estimates and assumptions. However, the effort needed for preparing a DCF model will also often result in the most accurate valuation. A DCF model allows the buyer to forecast value based on different scenarios and perform a sensitivity analysis. The discount rate is the cost of capital for the buyer or the Weighted Average Cost of Capital (WACC) to make this investment.
- Market Approach (Multiples & Comparable): The market approach is the most common valuation approach if comparable data is available. It has two main methods, comparative analysis & precedent transactions. Comparative company analysis (also known as “trading multiples” or “peer group analysis” or “equity comps” or “public market multiples”) is a relative valuation method in which you compare the current value of a business to other similar companies by looking at trading multiples like P/E, EV/EBITDA. A widespread means of establishing a ‘ballpark’ valuation used by private equity and corporates is the EBITDA multiple (that is, earnings before interest, tax, depreciation and amortisation multiplied by a ﬁgure commonly used for that industry or ﬁrms with similar ‘value characteristics’ and typical of recent past transactions) that could be taken to mean similar risk levels and growth rates.
Another type of valuation that relies to a certain extent on multiples is the comparable transaction methods. To use this method, you look at comparable transactions in that industry to a business with a similar model. You then compare them with relevant ratios and multiples such as Enterprise Value-to-EBITDA. With the precedent transactions method, you are looking for a critical factor that helps to determine the valuation. To do this, you compare the financials of similar companies and try to find a multiple that closely predicts the valuation. Once you know that, you can use that multiple to value the company being considered.
Another prominent application of the intrinsic approach is the dividend discount model (DDM). DDM is a quantitative method used for predicting the price of a company’s stock based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to its present value. It attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and considers the dividend payout factors and the market expected returns. If the value obtained from the DDM is higher than the current trading price of shares, then the stock is undervalued and qualifies for a buy, and vice versa.
- Cost Approach: The cost approach, which is not common in corporate finance, looks at what it costs to rebuild the business. This approach ignores any value creation or cash flow generation and only looks at things through the lens of “cost = value.” Another valuation method concerned is the ability to pay analysis. This approach looks at the maximum price an acquirer can pay for a business.
For example, if a private equity firm needs to hit a hurdle rate of 30%, what is the maximum price it can pay for the business? If the company does not continue to operate, a liquidation value will be estimated based on breaking up and selling the company’s assets. This value is usually significantly discounted as it assumes the assets will be sold as quickly as possible to any buyer.
- Asset-Based Approach: An asset-based approach focuses on a company’s net asset value. The net asset value (NAV) is identified by subtracting total liabilities from total assets. There is some room for interpretation in the valuation and how to measure the weight. Many stakeholders will also calculate the asset-based value and use it comprehensively in valuation comparisons.
The asset-based value may also be required for private companies in certain types of analysis as added due diligence. Furthermore, the asset-based value can also be an essential ratio when a company plans a sale or liquidation. However, this approach may not apply to tech startups with a light asset base and rely mainly on the productivity of their tech assets as the primary source of value.