Are you in the process of selling your company or thinking about acquiring another? Perhaps you’re simply curious about the value of your business? Thinking about the value of your business is relevant at various stages of the development of a company.
It’s not uncommon for entrepreneurs to over-value their company. For some, this is based on the unexploited vast potential they see in the future. For others, it’s simply because they lack the understanding about how to assess the value of a company. In conclusion, having unreasonably high expectations about the value of your company can be a serious obstacle to achieving the exit that you’re hoping for.
In this article, we will explore different methods you can use to assess how much your business is worth. It’s important to understand that there are objective factors, ones we can measure and calculate, and there are softer factors, which have an equally important impact on the value of your business. Understanding what impacts how much your business is worth can be useful, regardless if you want to sell your company or not.
Common methods used to value a business
While there are obviously variations which could be called valuation methods, there are three common methods to value a business:
- Discounted cash flow valuation
- Multiples valuation
- Asset based valuation
Aswath Damodaran, Professor of Corporate Finance and Valuations at Stern School of Business at New York University emphasised the point about subjectivity in valuations in this anecdote:
“I have valued Microsoft every year since 1986, the year of their IPO. 26 years in a row. Every year through 2011 when I valued Microsoft I found it to be overvalued. You name the price, I found it overvalued […] . If you really want to know why I found Microsoft to be overvalued all of these years, all you need to do is walk up my office and look around. What you’re going to see is a bunch of computers with fruits on the back.”
1. Discounted cash flow valuation
A DCF-based valuation is a thorough and detailed approach to estimate the value of a company. You have to analyse and assess future generated cash flows. This means understanding the products, price and quality and their market attractiveness. It also requires an analysis of company operations. Are there untapped cost efficiencies or economies-of-scale to leverage? Is working capital being managed well? Does the company have an adequate capital structure or is financing an issue?
The analysis is then converted into a projection of the future economics of the company. Sales and costs forecasts, as well as working capital, make the foundation for a cash-flow projection.
Finally, you need to assess the relevant discount factor, the WACC or weighted average cost of capital, with which you calculate the net present value of future cash flows. There is a mathematical formula to this, but it still entails a subjective assessment of certain elements such as the equity risk premium and the appropriate risk-free rate. It’s quite common to hear even seasoned venture capitalists state that they don’t calculate the wacc. They put up a discount rate based on experience and subjective reasoning.
2. Multiples-based business value methods
A widely used approach to valuing a company is multiples-based valuations. You look at the economics of your own company and compare these metrics with similar publicly traded companies or previous transactions.
Commonly used multiples are EV/Sales, EV/EBITDA, EV/EBIT and more.
When using metrics from comparable publicly traded companies, you use the valuations of these companies. You get these by multiplying the share price with the total number of outstanding shares. Following this approach, you are able to form an opinion on the value of your company based on what the stock market is willing to pay for your competitors.
Another set of metrics that you could use are from transactions of comparable companies. These metrics can be harder to obtain because many privately held transactions choose to withhold the information about what price was actually paid. Payment in acquisitions sometimes include earn-out structures or other arrangements that make it difficult to understand what value was actually put on the company.
An issue with multiples-based valuations is that it’s not always easy to find comparable companies. If you want to compare with publicly traded competitors, you will often find that these companies are 10-100 times bigger than your company. This raises the questions — are they truly comparable?
3. Asset based valuation
In this valuation method, the value of your company is based on the fair market value of total assets in the company after deducting all liabilities on your balance sheet. The fair market value of the assets has to include issues with technical or economic obsolescence, both for intangible and tangible assets. An example of this would be a company that holds value in the books for patents relating to outdated technology.
Asset based valuations disregard any future cash-flows. As such, this method is often employed in situations of liquidity issues or pure liquidation.
Is my business worth more to some than others?
In a functioning market, your company is worth what a willing and informed buyer is prepared to pay for it. It’s as simple as that. This may be either less or more than any solid business valuation would indicate. And it may also be more than another competitor would be willing to pay.
Why could your business be worth more to some than others? Well, it depends on the type of company you have and the market space. Let’s look at an example. Consider a situation where a company wants to control the supply of a raw material which is critical to its production. The company estimates that the importance of this raw material will increase in the future. The value attributed to acquiring the company supplying this raw material then exceeds the pure value of discounted future cash flows. It probably also exceeds the value which another company not operating in this specific supply chain would be willing to pay.
There are a number of other situations where one buyer would accept paying a premium on the base valuation: eliminating competition, acquiring critical competencies in the process or controlling a certain technology for example.
What factors determine my business value?
Many factors determine the value of a business. Different industries are valued differently. Attractiveness, scalability and positioning in the market is important. Here are some of the factors that impact business value:
Historical financial track record is the base for the business value
Nothing beats consistency. Steady and consistent sales and profits is always favoured. A volatile track record is not. Consistent sales and profits enable the company and its owners to plan ahead.
Even if the good years in the volatile scenario may lead to great profits, a potential investor would likely discard them as outliers in a valuation case. Volatility implies risk. Investors or potential buyers of your company know that in times when sales boomed, the organisation was probably stretched beyond its limits. This risks affecting the quality of the products or service, which in turn could lead either to lost customers or to disgruntled employees.
A company operating in an industry with steady or high growth prospects is likely to be more valuable. All other things being equal, even a start-up with no demonstrable stable sales record will enjoy a valuation boost if the relevant industry is growing. Most industries have valuation rules-of-thumb that don’t necessarily apply to other industries. This helps investors narrow down uncertainties.
Scalability and growth potential is key to the business value
Operating in a growing industry is obviously important, but it will not help your business if you have bottlenecks in your company. Scalability of the business model or operations is one of the most important characteristics of any company. Scalability enables you to leverage business opportunities and to mitigate risks associated with temporary set-backs. Ensuring that your company is agile and flexible is a key value driver.
Read more: Sales traction is important for value creation.
When thinking about the quality of your customer base, the concept of concentration is key. How do you achieve this? By managing your customer base and trying to avoid being too dependent on one or a few large customers. You shall avoid customer concentration. Your business will be significantly disrupted if you lose key customer. Having a broader customer base will likely improve profit margins by avoiding negotiating commercial terms with one significant customer who is likely to use the bargaining position.
Continuous competitive advantages
Building continuous competitive advantage relative to your competitors reflects positively on any valuation of your company. You can develop important advantages in many areas, e.g.:
- Superior production technology allowing for lower production costs, higher quality or quicker production speed
- Strong brand recognition giving you a uniquely loyal customer base
- Exceptionally skilled and loyal employees
A specific product is rarely a continuous competitive advantage. The product may be unique when it is introduced to the market, but competitors will catch up. Continuous competitive advantages do not materialise without specific management attention. Keep relentless focus on what sets your company apart and nurture those unique characteristics.
Financial strength of the company
It’s always important to manage the finances of your company. This is certainly also the case in a situation where you are considering an exit. Solid finances indicate a well managed company. Financial strength is not only about having a reasonable level of debt. It’s also about managing short-term financials measured in working capital.
What can I do to improve my business value?
If you consider above in the context of your own company, you can probably find a number of concrete actions you can take to improve the value of your business.
- Improve your products. If your company operates in a competitive landscape, find a way to improve the quality of your products. An alternative is to add value to the product or to excel in delivery capability or best-in-class customer service.
- Diversify your customer base. As discussed, concentration is a risk that directly translates into a lower valuation. Any potential buyer will discount for the risk that any large customer will leave for what ever reason.
- Manage your balance sheet. With a high-level of debt in the company, your equity value decreases despite a strong enterprise value. This is because your equity value equals the sum of your discounted cash-flow, the enterprise value, less the net debt in the company.
- Negative working capital consumes cash-flow. Make sure to manage your invoicing processes as well as working on supplier payment terms, your stock and your lead-times. Improvements will impact your equity value positively.
- Clean up your assets. If you have capital invested in assets which no longer are of critical importance to your primary business operations, put a plan in place to clean up your assets. Reduce your capital employed.
- Rigorous financial reporting and controlling. Make sure that your financial reporting and controlling is up to scratch. Moreover, if you are considering an exit from your company, the value of your company will increase if you are able to demonstrate that you are running a tight ship. Relevant reporting structures and clear responsibilities will give investors comfort that there will be no negative surprises.
Read more: Market potential is key to valuation.