Any entrepreneur seeking to raise funding from an outside investor will invariably be asked what they think their business is worth. Various business valuation methods are available and can be used to provide an estimated value.
Ultimately a business is worth what someone is prepared to pay for it.
These methods will always result in a range of valuations depending on the investors or entrepreneurs views and assumptions at the time. If the entrepreneur sets a too unrealistic valuation then the investor may well conclude that they have no understanding of the numbers involved or that they are deliberately trying to overvalue their business. Either way, it will harm the entrepreneurs credibility and probably contribute to a failed pitch for funding.
Why is the Valuation Important
The business valuation is a key part in the process of raising finance and determines what percentage of the business will ultimately be offered in return for the investment.
For example, if a business is currently valued at 450,000 then, for an investment of 50,000, it will need to offer 10% (50 / 500) of its equity. Likewise, if the business is valued at 200,000, it will need to offer 20% (50 / 250) of its equity for the same investment. The valuation placed on the business clearly impacts the level of funding available and the amount of equity it needs to sell in return for that funding.
Business Valuation Methods
There are various methods of estimating the value of a business all of which are based around one of the three financial statements, the balance sheet, income statement, and cash flow statement.
Balance Sheet Business Valuation Methods
This method attempts to value the business by estimating the value of the assets and liabilities shown on its balance sheet.
The starting point for this method is the latest balance sheet of the business which shows the book value of its assets and liabilities. The difference between the assets and liabilities is known as the net assets or net book value of the business.
The method involves adjusting both the assets and liabilities to reflect their current market value. Adjustments may arise, for example, from changes in the valuation of the property, equipment, inventory or accounts receivable. The adjusted net asset amount or adjusted book value is then taken as an estimate of the value of the business.
In this example, the adjusted book value of 260,000 can be used as the starting point valuation for subsequent funding negotiations.
Balance sheet business valuation methods are useful for stable businesses which have significant assets such as property or for manufacturing businesses. The problem with this method is that it does not take into account the future earnings of the business and is therefore not particularly suited to a startup operation.
Income Statement Business Valuation Methods
Income statement business valuation methods seek to estimate the value of the business based on information from the income statement, such as revenue, net income and others.
On of the main income statement based techniques is the PE multiple or Price Earnings multiple valuation. Using this method a multiple (based on industry knowledge and experience) is applied to the net income (earnings) of the business.
For example, in the income statement above the business shows a net income of 54,000. If the investor decides that for this type of business the appropriate multiple is 7.5, then they will estimate the value of the business along the following lines:
Valuation = Net income x Multiple Valuation = 54,000 x 7.5 = 405,000
In the above example the net income figure is taken from the income statement. In a private business is may be necessary to adjust the net income for unusual or non-recurring items to more accurately reflect the normal regular income of the business.
PE multiple business valuation methods are most suitable for valuing a business with an established profitable history. The difficulty with the method is that PE multiples are not readability available. The usual approach is to find PE multiples for comparable unquoted businesses or to discount the PE multiples available for a quoted business by a discount percentage, usually in the range of 30% to 50%..
One of the problems of basing the valuation on net income is that many start up businesses do not have a net income history on which to base the valuation. The revenue method attempts to solve this by applying a multiple to the revenue of the business. In the example above, if the agreed revenue multiple is 1.2, then the starting point for valuing the business would be calculated as follows:
Valuation = Revenue x Multiple Valuation = 360,000 x 1.2 = 432,000
Again the method suffers from the difficulty of agreeing the revenue or sales multiple. As with the PE multiple method multiples are found by making comparison with similar business either for unquoted businesses, if they are in the public domain, or by discounting the multiples of quoted businesses.
Cash Flow Business Valuation Methods
Cash based valuation methods are based on information from the cash flow statement. The most common method is to forecast the cash flows for the business and then discount these back to today’s value using the discounted cash flow (DCF) technique.
The discounted cash flow technique simply takes each future cash flow from the financial projection of the business and calculates the present value of the cash flow based on a discount rate. The discount rate reflects the return the investor needs and is a function of the risk involved in the investment.
Simple Example of DCF
Suppose a business generates only two cash flows, the first at the end of year 1, in the amount of 50,000, and the other at the end of year 2 in the amount of 90,000. If the return required is say 25%, reflecting the risk involved in the business, then the present value of the cash flows is calculated using the following formula.
PV = FV / (1 + i)n
PV = Present Value
FV = Future Value
i = Discount rate
n = Number of periods
In our example there are only two cash flows, and the present value is calculated by using the formula above on each cash flow, then adding them together.
PV = 50,000 / (1 + 25%)1 + 90,000 / (1 + 25%)2 PV = 97,600
What this means is that if the investor pays 97,600 today for their investment, and receives the two cash flows, they will make the required return of 25%.
Business DCF Valuation
To value a business the discounted cash flow technique described above can be applied to all the cash flows a business generates. As it is difficult to estimate how long a business will go on for, the normal approach when applying this technique is to utilize the free cash flows from the financial projections and add to this a residual value. The residual value is calculated assuming that the final year cash flow from the financial projection will continue for an indefinite period at a constant growth rate.
As the valuation is for the business itself which is funded by both debt and equity, the weighted average cost of capital (WACC) is used as the discount rate, and applied to the free cash flows and residual value of the business.
DCF Valuation Example
Suppose a business has free cash flows for years 1 to 5 of 90,000; 100,000; 150,000; 300,000; 250,000. It is anticipated that the cash flow at the end of year 5 will continue to grow at a rate of 2% for an indefinite period. The business is funded by a combination of debt and equity and has a weighted average cost of capital of 25%.
Residual Value Calculation
The first step is to calculate the residual value for the cash flows from year 6 onwards. The present value of the cash flows growing at a constant rate is given by the formula as follows:
PV = Pmt / (i - g)
PV = Present Value
Pmt = Periodic payment
i = Discount rate
g = Growth rate
In this example the residual value is calculated using the formula as follows:
i = Discount rate = WACC = 25% g = Growth rate = 5% Pmt = 250,000 x (1 + 5%) = 262,500 PV = Pmt / (i - g) PV = 262,500 / (25% - 5%) PV = 1,312,500
This is the present value at the end of year 5 of the estimated future cash flows that the business will generate from year 6 onwards.
Present Value of all Cash Flows
An estimate of the value of the business can now be obtained by applying the present value formula to each of the free cash flows from years 1 to 5 and the residual cash flow. This is summarized in the table below.
The discounted cash flow technique places a value on the business of 847,680.
Our discounted cash flow valuation calculator can be used to provide an estimated valuation of the future cash flows from a business’s operations.
The above is a very basic introduction to the principles involved in applying the various business valuation methods available. The rules regarding the raising of finance from potential investors are complex and vary from country to country. Professional advice should always be taken before discussing or issuing business valuations which should always be based on the specific needs of the business and the proposed transaction.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.