What is a valuation?
Say you are living in 300 B.C. Macedonia and you have just harvested your very first batch of rice. You had a particularly good harvest this year and decided to bring your 5 bags of rice to the market in hopes to trade them for soybeans. A nobleman stops in front of your stall, marvels at the quality of your rice, and proclaims that he would buy all 5 bags of rice in exchange for 2 bags of beans.
Before you promise the nobleman anything, you consult your uncle who is a tax-collector, he examines your rice and said one bag was worth 5 bags of beans because of its shine, quality, taste, and small yield per harvest. Your wife has snooped around on your behalf and reports that her friends’ husbands’ typically trade one bag of rice for 3 bags of beans.
You return to the nobleman the next day with all this information and eventually negotiate a good deal for your rice, and an added bonus of the nobleman’s pledge to supply you with the latest farming tools in exchange for a slightly discounted rate as his lifetime supplier.
Understanding the worth of your rice, product, business or company is crucial in establishing credibility and attracting good funding from investors. However, in addition to basing the value of your business on abstract and arbitrary measures (intangible skills and advantages) – like your team’s educational background and experience, there are also measures grounded on financial (standards, fluency, dependency, rules) that investors look at when determining if they are getting a good value for money.
What are the methods of valuation?
The valuation method employed varies between business to business and there is rarely a one-size-fit-all mold. Choosing the method of valuation depends on the market forces of the industry or sector the business is in, which can be anything from recent exits by players in the industry, current demand to supply ratio, or an investor’s appetite for impact investing. But to give you an idea of the importance and complexity of business valuation, we have put together some of the most common approaches to putting a justifiable price tag on your business.
Asset-based valuation is as it sounds: the value of the business is determined by its assets and liabilities. This approach uses the balance sheet elements to determine the business value by accumulating net fixed assets, liabilities, capital, and any other expenditures involved in establishing and maintaining the business to the valuation period. The process for asset-based valuations can be quite tedious as it involves accounting for all the little things such as operational expenditures, net amount available to equity shareholders, internally developed technology, and even office furniture.
This valuation approach is based on relativity – the value of a business can be gauged based on the market prices of assets or securities of similar businesses in the industry that have made a recent transaction. Assuming that similar assets sells at similar prices across the same industry, businesses employing the market-based valuation approach need to identify a price multiple, such as price-to-earning ratio (P/E) or price-to-cash flow (P/CF) as a benchmark for comparison.
While we will not be deep diving into the methods of the market-based valuation approach, the most common methods are the Public Company Comparables and Precendent Transactions. These two methods look at the comparable assets between similar businesses to account for their differing quantities, qualities and sizes, which is important when you want to determine the value of a share or stock.
The Discounted Cash Flow
Let’s say your company specializes in creating fully functional prosthetic eyes and you foresee a great demand for your products in the coming years as technology further refines the functionality. But how do you go about valuing a company whose products are the first of its kind? This is where the discounted cash flow method would be the best fit for valuation.
The discounted cash flow (DCF) method estimates the value of a business today based on its future cash flows. DCF analysis also considers the risks, timely return of investments, debt, and many other factors to provide a discount rate that will determine the present value. If the value determined by DCF analysis were higher than the cost of investment, investors would be more inclined to consider the opportunity.
The First Chicago Method
The First Chicago Method is a more detailed and elaborated version of the discounted cash flow approach. This method projects the performance of future cash flows through three scenarios: a “best case scenario”; a “base scenario”, and “a worst case scenario”. It also expects an exit event for the company and takes into account the terminal value, which is the residual value after the company’s final year of cash flow. Much like the discounted cash flow approach, there will be a discount rate given based on the investor’s expected rate of return. All of the present values calculated above will be averaged out to finally present a single value that reflects the company’s worth.
Since the First Chicago method uses multiple valuation methods instead of just depending on one, it is a preferred method of valuation by private equity firms and venture capitalists since it expounds the risks inherent and predicted in a company’s operations.
The above list is merely a subset of the various valuation methods and tools out there. There are different approaches to suit every purpose, business size, industry, and intent. For example, some older companies may prefer an asset-based approach for a valuation update, while some tech start-ups and SMEs may prefer the First Chicago Method.
How much your business is worth depends on many factors, from the return on investment to the current state of the economy. For entrepreneurs, figuring out your business’ value is as important as a self-reflection of your business performance, goals, and mission. Knowing your worth is the best thing you can bring to the table when raising a round of financing.
However, regardless of your reason to valuate your company, business owners should not valuate their own businesses even if they have the knowledge to do so. Aside from the lack of experience, there may be underlying biases that may prevent them from valuating strictly objectively.