How to value your company?
02. December 2015
Vahur Vallistu, project manager of Project Financing Department of Swedbank
The first issue to be considered when calculating the value of a business is the subjectivity of such a valuation. There are different methods to do that, all have theoretical reasoning, but these approaches and methods may often result in different outcomes.
Three most popular approaches to business valuation are assets-based business valuation, discounted cash flow method and market approach, e.g. comparing the subject business to similar businesses.
Assets-based business valuation approach focuses on a company’s net asset value, where value of the business is found by deducting liabilities from its total assets. Difference between the two is the business value. This is in essence minimum assessment for company’s value, as the value is determined only by potential revenues from the sale of assets - it does not take into consideration possible future cash flows. However, it serves as a good method for base case valuation.
In calculating business value, discounted cash flow method takes into consideration the company’s capacity to produce cash flows in the future. The higher the potential forecasted cash flow (and forecasted annual growth), the greater the business value for investors. Formulas with explanations are easily found on the Internet. Although it involves mathematical calculations, it is also a method that includes subjectivity. Cash flow forecasts are rarely precise, especially for the long term, and investors may have very different discount rates for future cash flows.
Market approach to business valuation tries to estimate business value by comparing it to similar businesses or already conducted transactions. This method assumes that references for values of similar businesses are found in order to calculate subject’s business value. For example, a comparable company has recently been sold and selling price is public. This method is mainly applicable for bigger enterprises, but increasing number of small and start-up enterprises are priced using that method nowadays. You can also look at funderbeam.com, which divides start-ups according to their field of activity and calculates, among other things, also their potential value.
All three mentioned methods are undoubtedly useful in calculating business value, but they may deviate from real valuations given by the investor. For example, potential investor may find that subject business possesses great synergy with his other investments (or on the contrary, it may reduce risks in relation to existing investments, because they differ in type or nature). However, even more important reason for price differences between models and reality is the fact that in the end everyone purchases the narrative, ambition and potential of the business and often invests in leaders of the enterprise. Enterprises with inspired leaders, who also have a solid business plan and strong team, are usually valued higher than some traditional method would suggest.
How to then calculate your business value? You can use some of the methods presented above (or look for some other because there are several alternatives available), you can ask advice from professionals (auditing companies or investment banks, although that might be fairly expensive solution), or you may take a personal angle - what would be the price you are willing to sell your business to someone else. All approaches have pros and cons. Ultimately, the value of a business is determined by the investor with his assessment to the potential of the company. Here, in addition to assets, cash flows and comparable transactions, promotion and sales to likely buyers play a big part as well.