It is important to note that there is no definitive valuation
methodology for a business, since most models rely upon various
subjective assumptions. Whichever business valuation model you use
or assumptions you make, ultimately the value of the business comes
down to what both parties agree it is worth.
Start-up businesses (especially pre-revenue ones) can get very
carried away with high business valuations. Think: would someone
buy what you have created so far at this valuation? Probably
not.
Usually, you will show the valuation of the business as a range,
by changing the key assumptions in the model.
There are various models that can be used to value a business.
Some of the more popular ones are outlined briefly below.
Net asset valuation model
This is the most basic form of valuing an existing business. It
looks at the net asset value as shown on the balance sheet, i.e.
all assets of the business, less liabilities.
Comment: The most basic model, but it does not
take account of the future earnings capability of the business and
its assets.
"Sweat equity" model
The value of the business corresponds to the total equity
injected, plus an amount for the entrepreneur's time taken to
develop the idea.
Comment: A fairly basic valuation model with
relatively few assumptions and variables.
Price/earnings model
This model is useful for calculating a valuation at the exit
point, e.g. after three to five years, to provide an estimate of
the investor's return on investment.
For a quoted company, the price/earnings ratio is the quoted
share price of the company divided by the (usually one year
forecast) earnings per share. Find an appropriate P/E ratio by (1)
comparing your business with similar quoted businesses and (2)
discounting the ratio (sometimes significantly) to reflect the
reality that your business is worth less than a quoted
counterpart.
Once you have established a P/E ratio, multiply the
business's projected annual net profit after tax (earnings) by
this figure, in order to assess the value of the business
(price).
For example, if the P/E ratio is 6 and your projected earnings
are £100,000, your P/E valuation for the business is
£600,000. This assumes that the future earnings of the
business are £100,000 per annum.
Comment: Determining a P/E ratio for your
business can be a very subjective exercise.
Discounted cash flow (DCF) model
An investor purchasing shares in a business is, in effect,
purchasing a share of the business's future cash flow (in the
long run broadly represented by profits after tax). The DCF model
discounts this cash flow back to a single figure, to derive a value
for the business, using an assumed discount rate.
The discount rate should reflect an investor's desired
investment return over the life of the investment.
Comment: Again, the choice of discount rate is
crucial and highly subjective.
Sales and profit multiples
This is a simple method that multiplies the sales or profits at
exit by a multiplier. The multipliers are based on industry
standards or sales of comparable businesses.
Comment: A good way of testing the
reasonableness of other valuation methods, although again the
multipliers are subjective.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
Specific Questions relating to this article should be addressed directly to the author.
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