In most cases, there comes a time at a business owner’s life when they need to raise external money for their company. Whether it’s for scaling the company, increasing human resources or for internationalisation, external funding can offer valuable support. Before the business owner can start to raise capital, they need to decide how big of a slice of the company pie an investor will get in return for their money. The process of determining how much the company is worth is called valuation.
This article will shed light on the available analysis methods for valuations. To create sustainable businesses and support companies that have a real chance to make a difference in the world, investors and entrepreneurs have to increase their understanding of the most common methods of valuations and the pitfalls associated with them.
We dive into three methods that are most often used to assess companies. We also illustrate the differences between the techniques and the best combinations.
Benchmarking, the discounted cash flow method and the analysis of intangibles are on our radar in addition to combinations of these. There are many additional methods in use today, but in this article, we will focus on the most common ones that we find to be the most useful. We also find there to be differences in valuation practices when it comes to different regions of the world. There is a wealth of information available on the internet if you are interested in other methods like the VC method, the Berkus method, the book value method, or the scorecard method.
Benchmark
Benchmarking is a common method used when estimating a company’s value. While it will give you a ballpark estimate of what the value of your company could be, it is far from being a perfect match for many modern companies.
Benchmark method derives a value for an asset by comparing historical transactions of similar assets. The problem arises when a company with a truly unique product, service, or a business model tries to compare itself to similar companies in the market. The company might get a fair valuation of its assets, but it is far more likely that their unique proposition remains hidden and yields no value.
For instance, any company claiming to bring about an innovation shouldn’t look towards utilising the benchmarking method. Also, companies that haven’t yet found commercial success with their product or service wouldn’t benefit from the benchmarking method.
Benchmarking is also often used internally. A company might be tempted to use its valuations from previous funding rounds to support an upcoming one. We wouldn’t recommend doing this without sufficient data to back it up as there’s a risk of value inflation. This would occur if the funds raised during the previous round weren’t spent most efficiently. There might also be substantial deflation if recent developments in the company would be overlooked.
Discounted cash flow
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. The method involves the assumption that the company will grow steadily over the years to come or that the investor will make an exit after a certain number of years. In both cases, the present value of future cash flows is calculated using a discount rate. The calculation uses specific formulas to evaluate a potential investment, but the primary assumption is that the invested money will be worth more in the future.
However, a startup company with a high valuation based on projections of future earnings seems somewhat wishful thinking. Using the DCF method is problematic with new companies as it is meant to estimate future cash flows by evaluating past ones. If a company is still at a “pre-revenue” stage, its past uneven earnings aren’t much of an indicator to forecast future profits.
The DCF method works best for companies with stable revenues on established markets because there is at least some level of certainty of overall market growth and how the company business will develop. In the current environment, with some similarities to IT-bubble back in 2000, DCF can paint a beautiful picture, but the reality might be something very different if the expected high growth is never reached.
Intangible asset valuation
Tangible assets used to represent the majority of a company’s value. However, nowadays, companies are more likely to be based on knowledge-intensive assets, which are called intangible assets (IA). These are assets like the key personnel that have much knowledge about the company’s product or the research and development work that the company has put into the product.
It has been estimated that about 80% of the growth driving and revenue generating assets of companies are now intangible. It is, therefore, safe to say that these assets drive a lot of the company’s value. However, measuring only the intangible value of a company is not sufficient to understand its actual value.
Benchmarking is often used with the IA method to have a reflection point and reinforce the estimate. Technology companies, for instance, are often knowledge-heavy and have much intangible value connected to the overall assets of the company, building its value higher. Therefore, it makes sense to select the IA method as the preliminary valuation tool and only use the benchmarking data to understand how the company fits in with the rest of the market.
Winning combination
Having a basic understanding of how different valuation methods work and what they measure is very important. Some methods might work better at analysing tech companies, and some might work for manufacturing businesses.
However, rather than using just one method, a combo of two or three might be the best option. If you own an established technology company that offers healthcare professionals a unique solution that measures the wellbeing of infants, your best bet at analysing its value is a combination of the DCF and IA. Why? Because the chances are that your company already has a steady inflow of revenue, but its success relies heavily on your staff’s performance and knowledge about the topic and your network of customers that have committed to your solution.
If you can find a similar company on the market, you might benefit from a benchmark analysis but only to give you a reference point. We can take a recent example of the IPOs of Lyft and Uber. Uber’s value was set around $76 billion, and Lyft went public at a $24 billion valuation. Even though the companies are providing a similar service, it doesn’t mean that their value is the same.
Summary
Many different characteristics and details form the real value of a company – even things you didn’t come to think of yourself. It is best to try to find the best combination of solutions taking into consideration the case and the context. If you use benchmarking, cash flow, and intangible asset valuations, you will be able to triangulate the value quite accurately and decrease the elements that usually distort the value.
When selecting a method of valuation, keep in mind that most valuation methods stem from a time when the focus was on manufacturing goods. We’ve all seen the makeup of companies transform from the industrial to the technological – from tangible to intangible – in the course of just a few decades. Companies have gone through a transformation, yet the way we give value to businesses hasn’t kept up with the change.
6/12/2019
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