Business Valuation in 5 minutes
This is a 5-minute read on Business Valuation for Start-Up Founders looking to understand the basic mechanism behind valuation.
Basics of Business Valuation
There are 3 common approaches for valuing a business
- Cost Approach – What is the cost to build a factory or what is the cost to build a new factory in place of an old one
- Market Approach – Compare with the valuation of listed companies in similar space or based on a private deal that has happened recently
- Discounted Cash Flow – Value derived by projecting the cash flows of a business into the future and getting the Present Value of these future cashflows
In any valuation exercise, a registered valuer will use at least 3 methods, assign weightage to the value attained through each method and arrive at a Fair Value.
In India, a valuation certificate can be issued only by a SEBI registered Category 1 Merchant Banker. Earlier this could be issued by Chartered Accountants as well but not anymore. Charges for the same can run from a lakh to even up to 15 lakhs depending on the size of your business and the valuation firm.
Before we get into the 3 most commonly used methods of valuation, we need to understand what a Valuation Multiple is.
Business Valuation Multiples
Valuation multiples are broadly of two types – Enterprise Value Multiples and Equity Value Multiples. If you are running a business, there are two common ways for you to raise money for it. You can either sell shares in your company to an investor or you can take a loan or debt from a bank. If you use both these methods to raise money there will be a certain portion of business owned by the Equity Investors and another portion owned by the Debt Investors. This means that at any point in time the total value of your business or the Enterprise Value is a sum of the Equity Value + Debt Value.
Enterprise Value = Net Debt + Equity Value
So, back to valuation multiples now. Common Enterprise Value (EV) multiples are EV/EBITDA, EV/Revenue, EV/EBIT. Common Equity Value (P) multiples are P/E, P/B, P/CF. To keep things simple we will look at EV/EBITDA and EV/Revenue multiples only for now.
You can go to Google Finance and Yahoo Finance to find out the values for these multiples for few companies to get a general sense of things.
Business Valuation Methods
Like we discussed earlier, a registered valuer will use at least 3 methods in the valuation exercise to arrive at the Fair Value of a business. The most commonly used methods are
- Comparable Companies Method
- Comparable Transactions Method or Precedent Transactions Method
- Discounted Cash Flow or DCF Method
Comparable Companies Method
If you were to value an e-commerce company you would choose companies like Amazon, eBay, Easy, Alibaba, etc as Comparable Companies. The valuation multiples for these companies are readily available online. We can calculate the Median of these values to arrive at the final multiples to be used for calculation.
For eg: If the median EV/Revenue multiple of the comparable companies is 6.5x and the Revenue for your business in the year where you turn profitable is Rs. 1,00,00,000. Then the EV = 10000000 * 6.5 = Rs. 6,50,00,000. Once you have the EV, you can subtract the net debt to arrive at the Equity Value of the business.
Of course, this is simplifying things a little too much. To the multiple, we will have to apply various discount factors like a Small Company Discount as your business is much smaller compared to Amazon, a Lack of Marketability Discount etc.
Comparable Transactions Method
Now, let’s look at the Comparable Transactions Method. In this case we look at the various Private Deals that have happened in the industry and find out the valuation multiples at which those transactions happened. The math remains the same as above. Although it sounds pretty simple it is incredibly difficult to find private deals data that are relevant to your business.
Discounted Cash Flow (DCF) Method
Lastly we have the Discounted Cash Flow method. Unlike the other two methods here we use the financial projections of the business and hence arrive at the Intrinsic Value of the business. Financials projections are usually made out to around 5 years from current financial year and for each of the 5 years you arrive at the Free Cash Flow to the Firm. From these yearly Free Cash Flows (FCF) you calculate the Present Enterprise Value by assigning a discount factor to each years FCF.
For eg: If a Company X has FCF for Year 1 till 5 as Rs. 100, 200, 300, 400, 500, to calculate the Present Enterprise Value, we have to first find out the Discounting Factor for each of the years from Year 1 to 5. The formula for Discount Factor is
Discount Factor = 1/(1+Discount Rate)^Time Period
Discount Rate is essentially equal to the Weighted Average Cost of Capital or WACC and the formula for WACC is
WACC = (Cost of Equity * % Equity) + (Cost of Debt * (1 – Tax Rate) * % Debt)
Cost of Equity = (Risk Free Rate + (Beta * Equity Risk Premium))
Cost of Debt = Avg. Yield on Debt
Risk Free Rate, Beta, Equity Risk Premium, Avg. Yield on Debt are values that change from country to country and Industry to Industry. So based on this data you can calculate your WACC and subsequently your Discount Rate and Discount Factor.
Once you calculate Discount Factor * FCF for each of the 5 years, you can sum up these to arrive at the Enterprise Value
Now you subtract the Net Debt from the Enterprise Value to find out the Equity Value
Equity Value = Enterprise Value – Net Debt
Now to find out the value of a single share you use the following formula
Value per share = Equity Value / Total No. of Shares
Once you have the Equity Value calculated with the three methods, you can assign weightage to the value obtained from each of the methods and arrive at a Fair Value of the Company.
Further Reading on Business Valuation
As I mentioned in the intro this is a basic 5 minute read on the vast topic of Business Valuation. If you want resources which can help you get a deeper understanding on the topic you can take a look at the following
If you are looking to get into the details of calculation with proper numbers and all the above video will be helpful
If you are looking to understand how an expert in Valuation thinks, the above Talk by Prof. Aswath Damodaran will be helpful
If you really want to get your hands dirty then you can probably take the course on Business Valuation by the CFI Institute and maybe even get a certification. This is what I did.