What is your business worth? Unofrtunately, there is no simple answer. Different people have different opinions on what defines value, making the question itself a tricky one. After all, how much your business is worth today could be quite different than how much you can actually sell it for at a later date. That’s why regularly reviewing the value of your business is so important.
As a startup founder, you will invariably face a time when you need to think about the valuation of your company. Entrepreneurs need to put a value on their startups in order to raise money, and investors need to put a value on their investments to generate liquidity. Whether you’re pre-revenue, post-revenue, in fundraising mode, or simply granting your emplyees stock options, you’ll need to have a valuation to operate from. When trying to determine this, it’s worth utilizing some best practices to justify your number and gain as much leverage as possible in these situations.
On that note, let’s take a look at three basic company valuation methods…
This type of valuation can be suitable for owners who treat their business as an investment rather than an income stream. It’s a straightforward approach that follows a simple rule: a company should not be worth more than the sum of its parts.
Imagine breaking your business up into the individual assets you own. Add them all up, subtract any liabilities, and you get the business value. Squarely focused on your ledger, this approach incorporates the net book value method, which calculates the cost of an asset minus depreciation.
Something else to keep in mind – since partial owners typically can’t access the value of assets, this approach is more apprpriate for businesses in mature industries where a lot of capital may be required. Similarly, this approach is not very accurate when it comes to valuing startups since young businesses don’t usually have a lot of assets at their disposal.
Comparable Worth Method
It doesn’t take an MBA to understand this approach – just let the market be your guide! The basic premise of the comparable worth approach is that an equity’s value should bear some resemblance to other equities in a similar class. Take a look at what similar businesses in your community or industry sold for, and you’ll get a good idea of your market value.
There are two primary comparable approaches. The first is the most common and looks at market comparables for a firm and its peers. Common market multiples include the following: enterprise value to sales (EV/S), price to earnings (P/E), price to book (P/B) and price to free cash flow (P/FCF). To get a better indication of how a firm compares to rivals, analysts can also look at how its margin levels compare. For instance, an activist investor could make the argument that a company with averages below peers is ready for a turnaround and subsequent increase in value should improvements occur.
The second approach looks at market transactions where similar firms, or at least similar divisions, have been bought out or acquired by other rivals, private equity firms or other classes of large, deep-pocketed investors. Using this approach, an investor can get a feel for the value of the equity being valued. Combined with using market statistics to compare a firm to key rivals, multiples can be estimated to come to a reasonable estimate of the value for a firm.
The Comparable Worth approach can be more appropriate for companies where a lot of comparable transactions can be reviewed, such as public companies in established industries or small businesses of similar type, size, and revenue in the same region.
In the context of the startup scene in Bangladesh, it can be quite difficult to value your company using this approach. Small, innovative startups don’t usually have a lot of similar public companies – food carts for example – and hence it can be impossible to acquire enough data in order to accurately value your startup using this method.
Discounted Cash Flow (DCF) Method
Taking comparable analysis one-step further, one can take financial information from a target’s publicly-traded peers and estimate a valuation based on its discounted cash flow (DCF) estimations. Considering the limitations of the methods mentioned above, this is widely regarded as one of the most effective ways to value a start-up.
DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free rate of return, the company’s costs of capital and the risk its stock faces. All of this will give you an appreciation for what drives share value, and that means you can put a more realistic price tag on the company’s stock.
In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it’s going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as “discounted” cash flow because cash in the future is worth less than cash today (see previous article on Time Value of Money).
For example, let’s say someone asked you to choose between receiving ৳100 today and receiving ৳100 in a year. Chances are you would take the money today, knowing that you could invest that ৳100 now and have more than ৳100 in a year’s time. If you turn that thinking on its head, you are saying that the amount that you’d have in one year is worth ৳100 dollars today – or the discounted value is ৳100. Make the same calculation for all the cash you expect a company to produce in the future and you have a good measure of the company’s value.
Of course, when it comes down to the essentials, there’s only one value that matters – the amount someone is willing to pay for it. However, choosing the right path to get there can present challenges that can only be identified by establishing the value of your business now and throughout the life cycle of your business.