Valuation methods, or rather the specific value of a business, is one of the most common question that I get. I will shortly explain the five most common valuation methods in this blog post.
Cashflow is a common metric to value a business. If the business earns $3 million in profit before interests, tax, amortization and depreciation, then that is the cashflow metric. Multiplying the cashflow metric with a value multiple from comparable publicly listed companies gives the value of a business.
We will describe how to come to the correct value multiple. We will also show which of below five alternative methods that is most commonly used to value a business.
The 5 most common valuation methods
There are five valuation methods to calculate the value of a business:
- Discounted future cashflow.
- Multiple valuation using comparable companies.
- Multiple valuation using recent transactions.
- Backtracked valuation.
- Asset valuation.
Later in this guide we will also describe three main adjustments when someone value a business.
Discounted future cashflow to value a business
Discounted cashflow means that you look at a cashflow forecast for the coming years and discount that cashflow to today’s value. It is for this reason that a 5 – 10-year financial forecast is asked for. The longer the forecast, the better the perceived precision in value calculation.
The discount rate, which is the investors return requirement, is important. Earning one future dollar is less worth to those with high return requirements than those with a lower return requirement.
A high return requirement gives a low value of a future, forecasted and discounted cashflow. A commonly used 25% by private equity investors is an example of a high return requirement. A low return requirement, say 12% commonly used by infrastructure investors, gives a high value of a business.
Financial theory and professionals will argue that the discount rate consist of the risk-free interest rate plus several risk factors. The theory is that the return requirement is low when inflation and interest rates are low. In real life however, return requirement has not changed much in the last 10-15 years. Despite low inflation and even negative interest rates. The investment opportunities have been plenty, and investors has remained with the same return requirement for years.
Multiple valuation using comparable companies
A common way to value a business is to look at the value of similar, publicly traded companies. A listed industrial company with $1 billion in revenue, traded at $117,- per share with 30 million shares is worth $3.5 billion on the stock market. If this billion-dollar company has a 35% EBITDA-margin they earn $350 million in EBITDA. A market value of $3.5 billion means that the EBITDA value multiple is 10x for this particular company.
It can be argued that similar businesses, in the same industry with similar revenue and EBITDA-margin can be worth 10x its last reported full-year EBITDA. This valuation method is called “multiple valuation using comparable companies”.
Multiple valuation using recent transactions
The most common method to value a business during the last few years has been multiple valuation using recent transactions as a reference.
Multiple valuation using recent transactions as a reference look at the EBITDA for recent bought and sold similar companies. Some adjustments are usually made if margins and profitability differ.
The downside with this valuation method is that it depends entirely on someone else having valued and acquired another although similar company. Maybe that company is also valued using multiples from an eeven earlier transaction. There is also a clear risk that each transaction tends to be valued slightly higher than the previous transaction with an assumption that value always grow.
The method has become the most commonly used method despite its clear downside.
The backtraked valuation is perhaps an even more odd method to value a business but is commonly used by venture capital investors. Not least when valuing young, scalable technology businesses with limited revenues where growth expectations are high. Elevating between different early stage founding rounds is an example when this method is used.
An 8 – 1o year fictive financial forecast is made and discounted with targeted 40-50% financial return on cashflow. Effort is then made to build a credibly business case for the assumed financial forecast.
Asset valuation means that the value of the equity and the assets in the company gives the value of the business. This method is commonly used in small mom and pop businesses where earnings are highly dependent upon the owner that is about to leave the company when sold. The method is also commonly used when valuing investment holding companies.
Adjustment when to value a business
There are two common adjustments when someone value a business, regardless of valuation method:
- Enterprise value (business value) vs. share value.
- Management adjustments
This article has described how to value a business. To know how much the shares are worth one also has to deduct all debt and similar obligations from above business values
Enterprise value is the common term for the value of a business. Deducting all interest-bearing debt and all non-interest-bearing obligations gives the net value of the shares. Tax obligations and pension obligations are examples of such deductions.
Management adjustments of a value is a common alternative to using different risk-adjusted financial requirements. Financial theory dictates that the discount ratios shall be risk-adjusted when discounting a future cashflow. This may become a bit complicated and theoretical o many entrepreneurs and non-financial professionals and they rather use a normalized, average financial return requirement to value a business. That value is then adjusted up and down with 5 – 20% in 5 – 10 different areas in order to get to the final value of the business.
Such management adjustments are qualitative judgments and includes the management team, the business model, the products, the market position and the growth potential to name a few. These adjustments are often seen as odd to financial valuation professionals but is seen as prudent by non-financial professionals. It’s often easier to talk about real-life strength and weakness then theorize about different risk-adjusted and weighted average cost of capital, as preferred by financial purists.
The multiple valuation methods are often quick and easy to use to get an overall idea of a value. The discounted cashflow method forces the company to plan and consider the likely future outlook and to put that forecast into numbers.
Not only one but several of above methods to value a business is used for the very largest and most complexed of transactions.