How to value a business: commonly used valuation methods

There were many lessons learned from tech’s boom period of 2021-22. One of the most tangible for founders and operators was that the correct valuation can make all the difference to a business’s growth and investment prospects. But, how do you value a business accurately? And what makes a ‘good’ or ‘bad’ valuation? Surely a business has an objective value, which everyone can agree on? 

If only it were that simple. Let’s run through some common ways to value businesses, discussing how valuation methods evolve and change depending on the company’s profile and scale.

What kinds of valuation do businesses need?

Businesses need different kinds of valuation at different stages. Some valuations are required from tax authorities at certain times in the year, while others will be determined at particular milestones, such as fundraising events, acquisitions or other liquidity events. A robust business valuation determines a company’s ability to attract investment, retain talent, and execute on its strategic mission.

However, there are many options available to senior leaders who are embarking on a valuation process. Some are more complicated than others, and different methods can be more or less useful depending on the business’s stage and profile. In this article, we will outline some of the most popular methods and the areas to be mindful of in each valuation method.

Why were company valuations inflated in 2021?

During the tech company boom period of 2021-22, inflated valuations were the norm. Meanwhile, tech companies were celebrating somewhat unrealistic valuations and record-level investment, pushing many tech companies into the unicorn category (valuation over $1 billion). 

The post-money valuation model was widely acknowledged as the industry standard for fair valuation, this multiplies the share price paid by the latest investor by the total number of shares in the business after the investment. The issue with the post-money valuation technique is that it does not account for the varied share classes, such as preferred stock or any negotiated conditions that apply to issued shares. 

Because of the unprecedented funding volumes channelled to tech companies by investors in 2021-22, post-money valuations created downstream impacts on companies raising subsequent funding rounds, resulting in more flat or down rounds compared to the historic average.

Common methods for business valuations

As we walk through some business valuation methods, it is important to remember that all valuations are a combination of art and science. When calculating a company valuation, in-depth knowledge of the industry, market growth and information about similar companies are helpful to avoid inflated valuations.

Asset-based valuation

The asset-based valuation method is the simplest technique involving the subtraction of liabilities from assets as listed on the company's balance sheet. Known as Net asset value (NAV), this is used to reflect their fair market value. This would enable investors to understand how much it would cost to effectively recreate the business in question based on the NAV. Net asset value is worked out by calculating the worth of total business assets and deducting the value of all liabilities in the business.

As an example, Business A has a total asset value of £150m. The total liabilities for Business A are valued at £42m. Based on the NAV model, the business value would be £108m. 

Earnings-based valuation

Price-to-earnings ratio is a great example of earnings-based valuations for businesses. The price-to-earnings ratio is worked out by dividing the share price of a business, by the earnings per share. The earnings per share (EPS) part of this equation is effectively net profit divided by how many shares there are in the company. 

For example, if the net profit is £1m and there are 500,000 shares issued, the earnings per share would equal £2. Therefore if the price per share was £22, divided by the earnings per share of £2 gives a price-to-earnings ratio of 11.

This ratio is used to compare against similar businesses in the same industry, if the ratio of Company A is relatively high in comparison to other businesses, then this could indicate Company A may be overpriced. Similarly, if the price-to-earnings ratio is relatively low then this could mean that the valuation of Company A is lower than it should be. Investors can then weigh up the possibility of investing in the company with more confidence.

Discounted cash flow (DCF) valuation

It’s very common to value businesses based on their expected future cash flows. A common cash flow-based valuation approach is the discounted cash flow method. The DCF method relies on prior numbers as well as cash flow projections, arriving at a discount rate for present cash flows. which in some cases can be adversely affected by external factors, such as trends or shifts in the market or a shock to raw material costs. Investors would utilise their industry knowledge and research to judge if the initial cash flow projections were acceptable. 

To complete a discounted cash flow analysis ahead of arriving at a DCF valuation, you need to apply a discount rate to the business’s cash flow projections to calculate the present value of future earnings. It is common to take the weighted average cost of capital as the de facto discount rate. 

As with any cash flow projection, one potential issue with DCF valuations is that any forward-looking cash flow estimate is inherently speculative, and investors should understand that a DCF valuation cannot account for all of the variables that may affect future cash flow.

Market-based valuation

Market-based business valuations are based on data of similar companies. This is easier with public companies since reporting and market prices are more accessible, however this can also be utilised for private companies. Comparing similar businesses if there is available data (both publicly and privately) is a simplistic yet incredibly useful method when determining the value of a business. This, combined with a multiple that is based on financial metrics provides a reasonably accurate valuation for investors.

Often referred to as the market method, or the comparables and multiples approach, the multiple is based on financial measurements — such as EBITDA (earnings before interest, tax, depreciation, and amortisation), EBIT (earnings before interest and tax), and NPBT (net profit before tax). Once calculated, this can be compared against the average price of similar companies in the same industry to determine a fair price.

Looking into market capitalisation, sales, mergers and acquisitions will help paint a general picture of the value of businesses that operate in the same or similar industries. Despite being a very simplistic approach to assessing the value of a business, it is a relatively quick method and would provide a scale or benchmark to apply to any potential investors.

Other considerations 

Some industries have unique methods for valuation. For example, a technology company might be valued based on user metrics or the strength of its intellectual property. Intellectual property can enhance the value of a company as it prevents competitors from being able to replicate the product or service offered by a business. This is very attractive for investors because it provides a stable foundation for growth with a less risky future return, hence why prices may be inflated for those with ‘valuable’ intellectual property.

Reputation and existing customer lists can also be valuable sources of information when assessing the value of a business. Assigning a numerical value can be very difficult, however reputation and relationships can take time and potentially a lot of cash to build.

How to value businesses of different sizes

Small business valuations

• Seller's Discretionary Earnings (SDE): Small businesses are often owner-operated, and SDE is a common metric for assessing the owner's total benefit, including salary, perks, and non-operational expenses.
• Asset-Based Methods: Small businesses may have a significant portion of their value tied to tangible assets. Adjusted Net Asset Value (NAV) can be a straightforward method.

Medium-sized business valuations

• Earnings-Based Methods: As businesses grow, earnings become a more critical factor. Earnings Multipliers (such as P/E ratios) and EBITDA multiples are often used.
• Market-Based Methods: Comparable Sales (Comps) become more relevant as there is a greater likelihood of finding similar businesses in the market.

Enterprise valuations

• Discounted Cash Flows (DCF): For larger, more complex enterprises, DCF is often used because it considers future cash flows and accounts for the time value of money. This method requires more financial modeling and forecasting.
• Market Capitalisation: For publicly traded enterprises, market capitalisation is a direct measure of their value. However, private enterprises of similar size and industry can be compared based on market metrics.

In a public company, the business’s valuation is constantly scrutinised and adjusted based on its financial fundamentals and market trends. The valuation of a public entity is normally taken as the company’s market capitalisation – namely, the number of shares in circulation multiplied by the price per share. 

Ensure your financial reporting is up-to-date

What is your business worth? Ledgy can help. Having an up-to-date cap table and accurate IFRS2 reporting software is essential for any forecasting work, audit, or valuation. Ledgy consolidates your reporting needs, customise and export reports in the formats you need in a few simple clicks. Ledgy’s automation enables you to manage any potential errors or complex data with ease, catering to international grant types, currencies, global mobility and jurisdiction-specific reporting, so you stay compliant everywhere.

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Content / resources:

https://valutico.com/valuing-a-company-using-the-multiples-approach/

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