When it comes to valuing a business, there are several methodologies you could use. Each methodology is different, with distinct advantages and disadvantages that may make them more suited to certain scenarios.
If you’re looking to value your business (or looking to value a business you’re trying to buy) and not sure which approach to take, here’s an outline of the main business valuation methods available – and the pros and cons of each.
Discounted Cash Flow
The DCF methodology is based on the premise of the income approach: that the value of a company is derived from the future cash flows expected to be produced by that company.
As its name suggests, the DCF methodology discounts these forecasted future cash flows to present value using a discount rate that takes into account the riskiness of a company’s estimated cash flows – in other words, the likelihood the cash flows will become real.
From here, the Terminal Value is then calculated, which is the estimated present value of all of the cash flows (in perpetuity) beyond the forecast period. In all instances, free cash flows are calculated by deducting tax, cash required for working capital and capital expenditure from operational cash flow.
This is a market-based approach, and also the most commonly used approach to valuing a business. It looks at the prices which comparable public companies are trading at, relative to their earnings, in order to arrive at comparable valuation multiples. The most well-known multiple is the “Price/Earnings” or “P/E” multiple.
Typically for valuations of smaller private companies, the method uses an enterprise value relative to earnings before interest, tax, depreciation and amortization (or EBITDA) (“EV/EBITDA“) for comparable companies. These valuation multiples are then applied to the Sustainable EBITDA of the company being valued to derive a valuation. Sustainable EBITDA is used in the calculation to remove the effect of once-off or extraordinary items which are not expected to reoccur.
The difference between the DCF and EV/EBITDA valuations will most likely be attributable to differences in forecasted cash flow growth rates between the company being valued and the industry comparable companies used in the EV/EBITDA valuation.
Venture Capital Method
Often used to value very early-stage businesses without much historical performance data, the Venture Capital method calculates a Terminal Value at a future date, when a venture capital investor assumes that they will be able to exit the investment. The Terminal Value is then discounted by the rate of return (over the period to exit) required by a venture capital investor.
The rates of return typically required by venture capital investors vary, depending on the stage of development of the company being valued.
Liquidation Value assumes that the value of a company is equal to the price that would be received if a company’s assets were to be sold on auction, less the third-party liabilities of the company.
Whether you’re buying a new start-up or selling an existing business to realise return on your investment, there are several different approaches to valuation you could take. Whichever valuation methodology (or combination of methodologies) you choose, it’s important to weigh up the pros and cons so that you’re getting the most accurate possible picture of what you’re buying or selling.