Valuation Methodologies: The Pros and Cons

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.

 

Pros:

  • It’s the most theoretically robust method of a business valuation (at EquityMaven, we use it as our primary valuation methodology). 

Cons:

  • It assumes that the company being valued will survive and operate in perpetuity. But this assumption is not always correct, particularly for young and start-up companies (although at EquityMaven, we adjust valuations for probability of survival).  

 

Multiples

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.

 

Pros: 

  • Well understood by the public, and relatively easy to understand.
  • More externally verifiable, as it relies on market multiples of comparable companies (or transactions) which have similar business activities and risks.

Cons:

  • It can be extremely difficult to find truly comparable companies with similar growth prospects, in order to calculate comparable trading multiples.  
  • As with the DCF methodology, it assumes that the company being valued will survive and operate in perpetuity. But this assumption is not always correct, particularly for young and start-up companies (although at EquityMaven, we adjust valuations for probability of survival). 

 

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. 

 

Pros: 

  • It enables early stage “pre-revenue” companies to be valued (because it’s easier to estimate a potential exit value at a future point in time, rather than estimating the cash flows prior to that point).
  • The discount rate (rate of return required) incorporates the fact that the company being valued is not liquid and has a relatively high risk of failure (non-survival). Further illiquidity discounts and survival probability weightings are therefore not needed.

Cons:

  • The method is typically used as a quick, indicative valuation only, and is not ideal if you’re looking for a really comprehensive or defendable valuation



Liquidation Value

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.

 

Pros: 

  • Most appropriate methodology for liquidation scenarios

Cons:

  • Most inappropriate methodology for firms that are stable and assumed to continue as a going concern

 

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.