What’s worse than buying something, only to realize that you got ripped off? Not much.
Now imagine that scenario on a large scale, such as overpaying for a business. That could be a serious problem.
But how do you assess valuation, and which methods are most effective? Moreover, why would a business executive need to assess their company’s valuation?
These are the questions we asked in an interview with Leon Grady, an investment banker at Armillary Private Capital in Wellington, New Zealand. Leon was kind enough to let us in on the world of company valuation; his answers are reflected in the content below, beginning with three methods for valuation.
Method 1: Discounted Cash Flow
Since not everyone is familiar with this term, let’s start off with a quick definition.
Investopedia defines Discounted cash flow as “a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment.”
In layman’s terms, you are basically trying to figure out what the current value is of the cash the company will generate in the future. The concept of the time value of money is important here, as a dollar in the future is not worth the same as a dollar today.
Discounted cash flow is considered the golden standard for valuations—it is very common. Keep in mind that this is based off of cash on hand, not profit. You can’t spend profit: you can only spend cash.
Method 2: Comparison Companies
This method takes the business in question and lines it up against competitors in the industry, comparing them across a multitude of areas using statistical data. It is useful to look at the median and upper and lower quartiles of the data of a company in order to get an accurate picture of where it stands in relation to its competition and where is better to invest money to be able to make profits.
A few other variables factor in. For example, you account for public and private companies differently; for private companies, you apply a liquidity discount. You can then arrive at a new set of discount rates that paints a good picture of where the company’s valuation stacks up to its competitors.
As a simple example, consider a can of Coke. You can buy it in a variety of different places: a grocery store, a ballgame, a gas station, etc. Each one of these places is going to sell the can at a different price.
Many factors come into play here (e.g., economies of scale, location, demand), but by comparing how much a can costs across many different vendors, you can get a good gauge on the value of a can of Coke.
Method 3: Future Maintainable Earnings
Future maintainable earnings as a valuation method is similar to discounted cash flow, but this method can be more useful in smaller companies where less information in available.
The idea behind the method is to see how a company has performed financially versus their budget in order to predict how well they will do in the future. If a company is consistently over or even under budget, it means they do not have a great grasp on the future performance of their business.
First, take a few historical years as a basis. Then, take the current year’s data and project it through the end of the current year (assuming no major changes). You can use this data to predict how the company will perform in the future, and you can even weigh certain years’ data differently.
But Why Do I Need To Know A Company’s Valuation?
Company valuations are important for a host of reasons. Let’s say you have a business that has no clients but has been working on a product for years; you’ll want an idea of what your product will be worth to consumers.
You will also want to know your value if you are buying a new business, selling your business, or even changing your current business model.
Even divvying up assets of an estate upon an individual’s passing could require a valuation. It is always best to be prepared with as much knowledge as possible before investing in, selling, or changing a business.
Which method is best?
This depends on the industry of the company in question, but ideally, using multiple methods of valuation is best. This will give you multiple points of data and will make it less likely for you to accept an outlier as the true valuation.
If you use the three methods above, you could take the mean of your three values. But if you are using five or more methods of valuation, you could always throw out the highest and lowest values to give yourself a more accurate viewpoint.
Hopefully, you are convinced that valuations are important. If so, you have some tools in your belt to get those valuations started!
Did we miss any crucial ways to go about a company’s valuation? Here are some great resources from around the web that will give you even more information on valuation methods:
VALUATION TECHNIQUES OVERVIEW from Street of Walls
Business Valuation: How much is your Business worth? from ET Small Biz
Valuation Methodologies from BizQuest