Business valuation is perhaps one of the most commonly used business benchmarks. Entrepreneur-based entertainment shows like Shark Tank have made business valuation a household concept, but they also highlight just how easy it can be to misvalue a company. As this metric can be easily skewed, in this article you will find some indications about how to value your business accurately.
Companies often overestimate what they are worth, but it can be just as dangerous to underestimate their value. Correctly determining a reasonable valuation and explaining it are crucial to the success of startups hoping to attract and retain investors.
Why value your business?
Evidently, a business will calculate its value if it has plans to sell it. However, some additional reasons include:
- Attracting investors
- Selling stock
- Applying for a bank loan
- Reviewing business growth
A solid business valuation can be used to better explain trends, highlight growth potential, and offer equity to investors.
How to calculate a business’ worth
There is more than one way to value your business. For small companies or startups, the multiples approach is often the best choice. For more complex organizations, it may be best to use the discounted cash flow (DCF) formula.
Multiples valuation approach
The underlying concept of this approach is that similar assets should sell for similar prices. It is a relatively simple approach that has been used for almost a century and is still used frequently to date.
In this process, a “multiple” is used to determine the value of a business, which should be the same for similar companies, such as companies in the same sector, of a similar size, and with comparable growth projects. For example, the multiple could be the ratio of a company’s share price compared earnings per share ratio, or the business value to earnings.
When assigning a multiple, it is important to research the selling prices of competitors and determine the actual multiples that apply to a number of comparable companies. Some examples of business value to earnings multiples are:
- Small businesses or single-worker organizations: 0.7 to 3
- Businesses in the IT and digital sector: 6 to 12
- Fintech companies: 7 to 15
This multiple is then applied to a company’s earnings to determine what the business is worth. For example, a Fintech company with a sustainable EBITDA of $10 million would be valued at between $70 and $150 million.
The simplicity of the multiples approach is one of its main advantages; however, the multiple used must be determined accurately by analyzing similar companies. It is also more difficult to use this approach for newly created companies or volatile sectors.
Discounted cash flow method
The DCF method for valuing a business is a bit more complicated than the multiples approach. This formula is used to understand the potential future cash flow of an investment and use it to determine how to value your business and the value of the business today.
The DCF formula is as follows:
DCF = (CF/(1+r)^1) + (CF/(1+r)^2) + … + (CF/1+r)^n)
Where CF is the cash flow for the year, r is the discount rate, and n is the number of years.
The discount rate is usually computed based on the investment or opportunity cost. It could range from anywhere between 1.5% to 15%. Evidently, the discount rate used can have a large impact on the final valuation, so it is important to study this aspect accurately.
The advantages of the DCF method are that it is widely used in the investment world and is considered to be one of the most robust valuation methods. On the other hand, it assumes that a company is going to survive and actually produce cash flows for a certain number of years, which may not always be the case.
Tips for presenting a business valuation
Once a business valuation has been obtained, explaining how this end number was obtained is just as important. Here are some tips on how to make a good impression on potential investors or partners:
- Don’t focus solely on the market evaluation
It’s tempting to revert to the overall market evaluation to explain every detail of the business valuation. However, while market data is a key part of the assessment, it is only a small part of the analysis. Focusing on the market rather than the actual business operations and growth can raise red flags.
- Stick to hard numbers and facts
Presentations should be kept as factual as possible, using hard numbers whenever possible. This includes sales numbers, ROI, cash flow, customer base, and costs. Clearly, some advantages that a business can bring are not based on numbers. The quality of the customer base and partnerships are two valuable assets that may have an added value that goes beyond revenue.
- Limit long-term forecasting (that is not backed up by data)
Cash flows should not be forecast too far into the future, as they will become less accurate the farther out the projection goes. Up to five years is generally enough for most businesses. For larger, more established organizations, projections may go past five years.
- Use visuals whenever possible
Try to avoid only using spreadsheets to showcase the data. Graphs and other visuals can make it easier for potential investors to get a general overview of the company. They will then review the source documents themselves if they need specifics.
A business evaluation is critical for any startup or small business looking to sell their business or attract investors. It is also essential to understanding the long-term growth of a company.
As has been discussed, there is more than one way of determining what a business is worth. Regardless of which method is used, one crucial aspect is understanding how to present the information to investors. The good news is that combining numbers with confidence and accurate visuals can easily convey the value of your business successfully.