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Expert Answers to Biz Questions
Listen in! Pick up some expert advice to a reader's question that we selected from CyberSchmooz.
How to Perform a Quick Valuation of Your Company
Valuing a company is far from a straightforward process. As with running the business itself, there are many different elements that need to be taken into consideration. This ranges from past profitability to established relationships with major suppliers.
Even those it requires plenty of work, performing a valuation isn’t rocket science – thankfully. In fact, there are a number of methods you can use to work out what your business is worth.
What’s the purpose of valuing a company?
Before getting into ‘how’ to perform a valuation, it’s important to explore ‘why’ you would want to do it. For some people, they will only view a company valuation as the precursor to it being sold off. In reality, there are several reasons why a business owner would want to go down this route.
Here are the four main ones:
- Sell the business: By getting a valuation, you can speed up the process of selling the business. In addition, you have a stronger starting point when it comes to negotiating terms with prospective buyers. Plus, the company’s value may actually be more than you initially envisaged.
- Generate equity capital: When you’re looking to issue new shares and welcome investment into the company, a valuation will assist with producing a fair price for all parties.
- Start an internal market for shares: If you want to distribute shares internally, such as with employees, a valuation will ensure this is done at a reasonable price.
- Invigorate management: Regular valuations can revitalize management in a number of ways. It can be done to reveal areas of a company that requires improvement, measure performance, and reward managers who are going above and beyond.
Now that is out the way, it’s time to focus on the techniques that will make the company valuation a reality.
Price to earnings ratio (P/E)
The price to earnings ratio (P/E) is a simplified method for judging the value of a business. Essentially, it takes the post-tax profits of an established company and multiplies it with an appropriate P/E ratio.
For example, a business might have generated a $200,000 post-tax profit. This is then multiplied by a P/E ratio of 10, which ultimately leads to the business being valued at $2,000,000.
The main issue with this method is determining the right P/E ratio for your business. This ratio varies drastically, depending on the industry. A high-growth company such as a tech startup will typically benefit from a high P/E ratio. On the other hand, a business with less potential to grow beyond its current profit margins will tend to have a lower P/E ratio.
Other factors also come into the equation. A company that has a proven track record for producing yearly profits will usually be rewarded with a bigger P/E ratio. The same can also be said for those with a high forecast profit growth.
Value current business assets
If your business comprises an extensive amount of tangible assets, this valuation method is a suitable one. You can total up all of your physical assets, including any stock, machinery, and buildings you may own. Once you have a figure for your assets, your liabilities are taken away from it to give you an overall asset valuation.
When doing this, economic reality has to be taken into consideration. For instance, old stock will usually have to be sold at a discounted price. Equipment will also have been depreciated in value over time. This will ultimately affect the overall value of your business assets.
There’s also another problem with this method: it doesn’t take into account intangible assets or future earnings. As a result, the valuation will generally be the lowest given compared to other techniques listed.
Entry cost
How much would it cost to start a similar business to yours from scratch? To get an accurate figure, you will need to calculate the likes of:
- Financing options for funding
- Buying assets
- Developing products and services
- Hiring and training employees
- Marketing and time to build a customer base
When you have an accurate estimation, this can be used as a way of valuing your current business.
Analyze the intangibles
A business possesses a wide variety of intangible assets. Trying to quantify these into a monetary figure is difficult. Unlike fixed assets and stock – aka items that are tangible and feature a clearly defined value – intangible assets are worth as much as someone is willing to pay for them.
One of the most significant intangible assets is your company’s reputation capital. This incorporates elements such as:
- Reviews
- Brand identity
- Stakeholder trust
- Word of mouth
There’s a notable issue when it comes to measuring reputation: it’s subjective. With that said, it incorporates various other components – such as those mentioned above – which can be measured.
In addition, the reputation of your company will affect the likes of your stock price and the value of products/services. If your reputation is strong, it will result in additional sales, customer retention, and enhanced marketing. This then improves the rest of your business performance, which, ultimately, boosts its overall value.
Discounted cash flow
This complex method for business valuation is only suitable for a small number of establishments. For instance, a business that is stable and features a predictable stream of long-term profits can utilize discounted cash flow.
As for how it works, it goes several years into the future to forecast the expected cash flow of a business. This cash flow will be worth more than what it is today due to added dividends and residual value.
In today’s world, however, the value of this future cash flow is discounted. The discounted rate is usually 15% to 25%, and this is applied to each yearly dividend. This discount rate is applied because it takes into account the risks involved and the time value of money. The latter is where currency inflation is considered - $1 today is valued at more than $1 from a year’s time.
Confused? Don’t worry: you can get a better idea of how it works by using this discounted cash flow calculator.
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