In my last 30 years of helping companies grow, one of the most common questions I have come across is “how much is my company worth?”.
Bringing together the financial (valuation) and non-financial (evaluation) pieces of the puzzle will help you determine the value of a company. Valuation refers to the economic value you place on a company. It is important to not get confused between valuation and price. A company’s valuation is the financial assessment of a business determined by one or more accepted valuation methods. Here are 3 valuation approaches you need to know about.
1. Income Approach (Discounted Cash Flow) – Discounted Cash Flow (DCF) is one of the most popular valuation methods because it takes account of the future prospects and not just the historical performance of the company. DCF bases the valuation of a company on the net present value of projected cash flows. Future cash flows are given a present-day value by applying a discount rate specific to your target company. Weighted Average Cost of Capital (WAAC) is often used to determine the discount rate. WACC gives you a way to look at the capital structure of a company. It considers two familiar kinds of capital: debt and equity.
WAAC = (Cost of Equity) (%Equity) + (Cost of Debt) (%Debt)
DCF keys in on the operational efficiency of a business and recognizes the time value of money. That is the reason I recommend discounted cash flow as an essential part of any valuation process.
2. Asset Approach (Liquidation Value) – This approach answers the question: What would the company be worth if it is closed down today?Here you estimate the value of the assets the company hold, particularly if the company owns real estate or large pieces of capital equipment. Calculating the liquidation value gives you a better idea of what a bank might lend in the form of an asset loan. This in turn will indicate a “floor value”- the least the company is realistically worth.
This method is appropriate for estimating the value of:
- A business that continues to generate losses
- A business that is to be liquidated
- Where net book value is standard in the industry in which the company operates (real estate holding companies)
3. Market Approach (Transaction Comparables)- The final method we review here is completed transactions comparables, which are recent deals similar to the one you are contemplating. Market transactions are used as valuation evidence. You can find information on these, through sources like S & P CapitalIQ, Factset Mergerstat, DealStats, Bizcomps, and Done Deals. Transaction comps serve as a “reality check” when starting to assess the financial picture.
They can give you a perspective on what is happening in the market space in which your deal would take place.
The task of valuation can seem daunting, especially since it is based on predictions of future conditions and the vagaries of incomplete data. I recommend a balanced approach drawing on the 3 techniques given above. The 3 techniques work well together because the first is based on the income statement, second on the balance sheet and the third on a review of what is happening in the market. You will arrive at a different value for each of the methods. You can then triangulate, reconcile, and weight these results to arrive at a single number for your valuation.
Bonus Tip: You should never let numbers alone dictate the value of a business.