How can you accurately value a business? Whilst the obvious answer may be to go straight to the traditional valuation methodologies often available in textbooks or online - this can be the most fundamental mistake. Peter Smith in Maven’s North East investment team sets out his thoughts on the most important drivers when valuing a business.
Valuing a business, particularly an early-stage one, is a difficult process that requires a blend of art and science. If the value of the business is too high, you may scare off potential investors and block the exit strategies suitable for your circumstances. Value it too low and you may end up giving away control of your business at a fraction of its value. Finding the right balance between the two is difficult but essential to providing an accurate company valuation.
Company valuation is the process of assessing the total economic value of a business and its assets and getting to understand the true intrinsic value of the business. During this process, all aspects of a business are calculated to determine the current worth of a business. The total value of the business is called the Enterprise Value (EV).
The enterprise value is equal to the sum of the equity value, the net debt position, and a normalised working capital position. The buyers offered enterprise value is predicated on the following assumptions: (i) cash-free and debt-free basis; and (ii) the business will be acquired with a normal level of working capital.
What are the valuation methodologies? The value of an item refers to the price for an asset that a reasonable buyer and a reasonable seller would agree to in a transaction. The three main approaches to business valuation are from the earnings approach, market approach or asset valuation.
Earnings based valuation - The earnings approach is still a widely used method. The earnings approach processes the intrinsic value of the business through calculating the present value of the expected future cash flows, discounted at the appropriate discount rate. Unlike relative forms of valuation that look at comparable companies, earnings-based valuation looks only at the inherent value of a business on its own. Therefore, if someone is purchasing a business, the number one factor to determine their purchase price is the amount of money it will make in the future. This includes creating a discounted cash flow and project a company’s unlevered free cash flow and its terminal value, and then you discount both back to their present values and add them to estimate the company’s intrinsic value.
Market valuation - Comparable company analysis is a relative valuation method. This includes in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method. The types of trading multiples typically change for each sector given the market dynamics. For example, a technology business can be valued on a multiple of annual recurring revenues (ARR) whereas a manufacturing/engineering will be based on an EBITDA multiple. The theoretical approach to this is that the purchaser – particularly a strategic acquirer – will look at the payback period until the acquisition will be deliver a positive return. The fundamentals come down to how much is the buyer willing to pay for the shares, business, or assets?
Cost approach - One of the most straightforward methods of valuing a company is to calculate its book value using information from its balance sheet. Due to the simplicity of this method, however, it’s notably unreliable. An asset-based approach is a type of business valuation that focuses on a company's net asset value. The net asset value is identified by subtracting total liabilities from total assets. There is some room for interpretation in terms of deciding which of the company's assets and liabilities to include in the valuation and how to measure the worth of each. Unlike other methods, such as the income approach, the asset-based method disregards a company’s prospective earnings.
A successful deal is often driven by the realistic expectations of the seller and the buyer. Typically, there is an investor or strategic acquirer for most business types, but it is very important to get the fundamentals correct first. The most successful deals have required the alignment of many different factors, such as market conditions, sale timing and speaking with motivated buyers.
These core values are seen across the Maven portfolio where we’ve backed a number of businesses across a range of sectors with strong management teams operating in expanding markets with opportunities for growth.
It’s hard to think of a business or sector which hasn’t been affected by the COVID-19 pandemic. The fact that many entrepreneurs are experiencing success and growth despite the challenging environment in which we currently operate is testament to the strength of the UK economy. If you have a solid plan and believe in your concept, then speak to Maven’s local team about your current and future needs, and our experienced investment professionals will be able to guide you on your funding requirements.
Subscribe to Maven North East news and updates
Keep up-to-date with all the latest news and insights from Maven, including new investments, events and our blog.