Valuation for Dummies
So, how does one value a company?
Understanding the economic value of a company is critical for both shareholders and investors. With this understanding, comes a variety of benefits such as: 1) positioning the company for sale at a fair value, 2) an updated level for new or additional funding, 3) understanding partner ownership or purchase/sell down options, 4) taxation, 5) implementing proper insurance coverage, and, potentially, 6) partner divestment or, worse a value for divorce proceedings or death. Depending on the specific reason for a valuation, a company or stakeholder may want the valuation as high as possible and an investor may want the valuation as low as possible. Therefore, how does one value a company?
There are six (6) basic valuation methods:
1. Discounted Cash Flow (“DCF”) or Income Approach
2. Comparable Company Analysis (“Comps”) or Precedent Transaction Approach
3. Asset Approach
4. Times Revenue Method
5. Market Capitalization Method
6. Cost Approach
Overview:
Comprehending the big picture. Establishing a fundamental understanding of company valuation techniques, relative and intrinsic, before attempting to mathematically calculate the value of a company, is the most important step. A company valuation incorporates important statistics and facts, tangible and intangible, about a company to estimate either the current worth, or to predict a projected worth. However, the possibility of the aforementioned purposes to applying a value to a company might not fit everyone’s modus operandi.
Should a practitioner still perform and/or receive a valuation of their company? Yes, of course. Having a proper valuation is necessary when seeking investors, deciding ownership percentages, employee stock options, and even in divorce proceedings. Since life can be quite unpredictable, it is best that business owners and investors understand a business’s worth.
Luckily enough, there are a number of valuation methods available, but the caveat of this is choosing the valuation methodology (or methodologies) to align with overall goals becomes more difficult. Each method has its pros and cons, and on top of that, some methods are immensely more detailed and complicated than others. Some valuation methods are executed through the evaluation of assets, others depend on equity, while one is subjective to other company transactions and/or price multiples. Most valuation specialists have their preferred valuation method, but all companies are different and ever-changing. If a valuation was furnished for a company in the past, another analysis with the same method, or a different one, may prove to be valuable. With this, we’ll compare each of the six (6) methods:
- Discounted Cash Flow (“DCF”) or Income Approach:
DCF analysis uses a complex financial model to predict future unlevered free cash flow, then uses the company’s weighted average cost of capital (“WACC”) to discount the value back to the present, hence the name. The DCF method considers inflation when adjusting, which may be useful for a particular company. To complete a DCF valuation, an analyst or specialist will develop a detailed financial model, populated with a multitude of details and assumptions. This method is easily one of the more complicated methods, but as a result, it is often times very accurate. Another benefit of going through the labor of building a sophisticated financial model is that this allows the analyst or specialist to perform what-if and sensitivity analysis taking in to account various potential future events, such as: unexpected changes in taxes or growth rates. A concern with the DCF valuation method is that the results are largely dependent on assumptions in the financial model such as growth rate, discount rate, and others.
2. Comparable Company Analysis or Precedent Transaction Approach
Comparable company analysis (public company comps) and precedent transaction analysis (private transaction or M&A company comps) are referred to as relative business valuation methods, meaning they solely depend implied assumptions, meaning that the company being valued should be same, or at least the same, as its competitors. These methods are considered the most subjective but provide a high-level benchmark for analysis. The reason that this method is so subjective is because you are valuing your company based on a company you think is comparable. How these comps are decided depends on what the analyst or specialist would like to highlight. This can be the price to earnings ratio, enterprise value to earnings before interest, taxes, depreciation and amortization ratio, or another multiple.
3. Asset Approach
There are two subcategories that comprise the Asset-Based valuation method. The first of which is called the “Going Concern” method. This method works under the assumption that the business being valued will continue functioning and is not selling off its assets. The result of the Going Concern method is the total equity of the company, which is assets minus liability.
The second subcategory of the Asset-Based valuation method is the Liquidation Asset-Based valuation method. While the Going Concern method assumes that the business will continue operation, the Liquidation method assumes exactly the opposite. This method’s assumption is that the company is going to sell off all of its assets and retire all of its liabilities. The resulting value after doing so is the value of the company.
These three valuation methods, DCF, Comps, and Asset Approaches, are often regarded as three of the most frequently used valuation methods. However, there are a few auxiliary methods that can be used to replace or reinforce the three main methods of valuation. Most of the time, there will need to be verbal articulation to confirm a company’s value from one valuation with similar results relative to other valuations. Thus, these secondary valuation methods are essential for proving to investors, buyers, or judges to value a business accurately.
4. Times Revenue Method
The Times Revenue valuation method works best for companies that are currently small but looking to break out. This is because the Times Revenue method estimates the maximum value that a company can achieve in the future. The steps are simple: take current revenues and multiply them by a factor to determine the highest value of revenues achievable for the company. The factor that revenues are multiplied by are dependent on the industry, business, economy, and other factors. The main downfall of this method is that profits and revenues are not reflective of each other. A company can earn great revenue, which will cause the Times Revenue method to give it a high value, but in reality, the company is spending its way to the grave.
5. Market Capitalization Method
The Market Capitalization Method is probably the simplest method of valuation. There are only two factors that go into the Market Capitalization method, the price of a share in the company and the total number of shares outstanding. These two values are multiplied, and the product is the Market Capitalization value.
6. Cost Approach
The final valuation method we will be discussing is the Cost Approach. This method is less common than the previous methods listed. The premise of the Cost Approach is that the value of a company is the cost it would take to rebuild the company from scratch. Given the approach, it is mostly applicable to Real Estate.
Always remember, business valuations vary from method to method, so don’t be surprised if the first method attempted gives an unexpected result. Valuations can also be given as a range to give the best representation of a company, and this can also be achieved by providing the average value of a few of the valuation methods. Lastly, there are plenty of other valuation methods to be performed, which could ultimately provide the most precise value of a business.
Sam Stokes
