Company Valuation Basics: An Introductory Guide to Essential Methods

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Published by Mateusz Muszynski
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As valuations for many technology-driven businesses apart from those operating in the artificial intelligence space have turned down significantly since 2022, we’re going to take a look into company valuations and provide an in-depth guide as to how companies of various industries are valued under an M&A perspective.

First and foremost, company valuation is a step during the company sale process that tries to identify a company’s true economic worth — the actual facts and figures that show the value of a business in terms of its ability to generate profit, assets and liabilities, market competition and future opportunities.

Apart from assigning monetary value, company valuation also is an efficient strategic tool that provides an extensive analysis to make informed decisions in matters concerning a company’s investments, M&A and planning.

Background on M&A — understanding valuations and their impact

Various methods can be employed for how do I value my business and hence choosing the most suitable one based on the individual characteristics of a specific business, company, and sector is very important. Approaches like the cost-based methods, profits or excess-earnings-based methods, relative value or multiple approaches, asset-based valuation and Discounted Cash Flow (DCF) each provide their individual, distinctive insights on a company’s economic worth.

Driving factors affecting company valuations

Apart from the choice of valuation methods, market conditions, financial performance, business model, industry trends and intangible assets can each significantly affect a company’s value:

1. Economic conditions

During economic downtime or recession, valuations can be negatively influenced by a reduced appetite for risk. Moreover, due to higher costs, companies with minimal or flat revenues may see their earnings drop, unless they are able to index their prices or have a significant pricing power. 

2. Financial performance

The overall position and performance of a business such as profitability, liquidity, repayment capacity, financial efficiency and solvency determines the overall value of the business to a large degree. In addition, many other aspects contribute to the value of a business including capital structure, CAPEX requirements and aspects of balance sheet leverage, just to name a few.

3. Business Model

For each individual company, the business model plays an important role in determining its valuation. This includes factors such as the revenue model (one-off vs. recurring), scalability and growth as well as geographic diversification, client concentration and pricing power. Furthermore, it is also important to consider why do companies buy other companies and what tailwinds the future can bring. A well-thought-out development strategy can have a profound impact on a business’s valuation. The way a company plans and executes its growth initiatives directly affects its financial performance and market position, both of which are critical factors in determining its value.

4. Industry trends

Factors such as industry concentration, competitive advantages, general sector outlooks and revenue trends can influence the valuations of a particular business in comparison to its sector peers. Looking across industries, valuation may differ significantly: as an example, a SaaS (software-as-a-service) company would enjoy a much higher valuation multiple than a manufacturing company.

5. Intangible assets and goodwill

Intangible assets are assets that are non-physical. These include patents, copyrights, goodwill, trademarks, software and others. Valuing intangible assets is usually very difficult due to a lack of physical substance and their fluctuating market values. Goodwill, in particular, from past acquisitions, should always be re-evaluated under current market conditions when evaluating a company, especially with the assistance of Acquisition Advisory Services.

Overview of major valuation methods

There are several methods employed for this purpose, each with its own strengths and limitations.

Discounted Cash Flow (DCF) 

Makes an estimate of the value of an investment based on expected future cash flows. This focused approach is well-suited to companies with growth prospects and a certain degree of confidence in the projections. However, it assumes future cash flows will grow at a projected rate, which may not always be accurate. Also, it does not consider valuations of competitors or industry peers but strives to arrive at an absolute figure for a particular, individual business.

Multiples or ‘relative-value’

Valuation methods based on multiples compare a business’s financial ratios with those of similar companies or industry peers. This method is simple to use and easy to compare across the sector, but finding truly comparable companies can be difficult. Also, comparison across geographies can sometimes complicate relative-value benchmarking due to accounting differences and country risks.

Asset-based valuation

Subtracting liabilities from assets determines a company’s net assets. This method is straightforward and useful for liquidation scenarios but may not capture the value of intangible assets or future earning potential.

Focus 1 — Discounted Cash Flow (DCF) method

The Discounted Cash Flow (DCF) method is a tool used to value a company or asset that incorporates the time value of money. The method assesses the potential worth of an investment in a way so investors can ascertain the present value of future cash flows, possible returns and the time such returns will be available.

The model is typically created based on historical financial accounts whereby the free cash flow of the business in the past can be evaluated and the income statements predicted for the future. To accurately assess the potential of the investment as the business’s growth rate normalises the discount rate — which indicates the relevance of the time value of money — as well as a reliable long-term growth rate, must be calculated and a terminal value set. The Weighted Average Cost of Capital (WACC) is usually the appropriate discount rate in cases where steady free cash flow is being used, or in other cases an appropriate risk-free rate may be used. Additionally, considering why would a company want to be acquired is essential as it can significantly impact the valuation and investment strategy.

Discounted Cash Flow (DCF) valuation in a nutshell

  • The concept of the time value money is utilised to estimate the present value of future cash flows.
  • It involves the assessment of long-term growth rates according to the development strategy and planned investments, projections of Free Cash Flows (FCFs) and terminal value, historical financial statements and the determination of the discount rate (risk-free rate or WACC).

Focus 2 — Relative value and market multiples 

In M&A and private equity, alongside DCF, the most prominent valuation methodology is relative value using multiples of peer-group companies. Depending on the relevant industry, and the availability of data, M&A advisers and private equity advisors generate benchmarks based on comparable company analysis (CCA) and comparable transaction analysis (CTA), which derive value from market data. CCA values a target company based on the market’s assessment of its worth compared to similar publicly traded companies, while CTA estimates value by analysing historical transaction prices for similar companies, assuming that these past prices reflect the target company’s value.

The multiples used typically are sales or revenue-based multiples in the technology space or for early-stage, loss-making companies and EBITDA, cash-flow or earning-based multiples for more mature companies. 

If a company’s indicative valuation is lower than the average of the market peer benchmark, it could signify that there is an undervalued opportunity.

Types of multiples used in multiple-based valuation in a nutshell

The below financial indicators are among the most widely used measures in M&A.

Due to its ability to compare companies with different capital investments, debts, and tax profiles. EV/EBITDA is especially useful in benchmarking a wide range of companies.

  • Sales or Revenue multiples such as Price to Sales (P/S) or Enterprise Value to Sales (EV/S) is typically used for early-stage companies, as they are frequently not profitable yet at that stage of their lifecycle. 
  • Cash-flow or EBITDA-based multiples such as Enterprise Value to Earnings before Interest Taxes Depreciation and Amortisation (EV/EBITDA) for more mature companies.
  • Earnings-based multiples such as Price to Earnings (P/E) for stable companies that tend to stay profitable over the business cycle. 

Pros and cons of valuation methods

Each approach to valuation carries its own set of advantages and disadvantages, making them suitable for different scenarios. We are looking at the pros and cons of using the Discounted Cash Flow (DCF) and market multiples methods as examples.

DCF valuation

Overall, the main drawback is that this method requires a vast number of assumptions and only small changes in a single variable such as the WACC can have immense sensitivity on the terminal value and hence the overall valuation. In addition, the. DCF method tends to make an analysis of a company’s value without that of its competitors.

  • Reflects risk, uncertainties and opportunity cost, and accounts for cash flows.
  • Not only focussed on profits or earnings, which can be affected by losses or gains from non-cash items, such as depreciation or taxes.
  • Highly flexible and adjustable to a particular business without the need for a peer group.
  • Highly condition-dependent (discount rate, WACC, terminal value).
  • Sensitive to assumptions used.
  • Not suitable for early-stage businesses or businesses with negative cash flows.

Multiple-based valuation

Multiple-based valuation methods offer simplicity and comparability but should be rather treaded as preliminary and used in conjunction with other valuation techniques and qualitative analysis to provide a more comprehensive view of a company’s worth.

  • Allow for easy comparison of a company’s valuation with its industry peers or competitors.
  • Relatively straightforward to calculate and understand, making them accessible to a wide range of investors.
  • Reflect market sentiment and investor expectations, providing insights into how the market values a particular company.
  • Rely solely on historical or current market data and do not consider the future growth prospects or qualitative factors of a company.
  • Different industries may have distinct norms for valuation multiples, making it challenging to compare companies from diverse sectors accurately.
  • Highly sensitive to market fluctuations and investor sentiment, which can lead to rapid changes in valuation.

Choosing the right valuation method

Determine why you need the valuation. Is it for selling or buying a business, securing financing, tax planning, or internal decision-making? The purpose will guide your choice of method.

Consider the nature of the business and know why do companies merge because in most cases, some businesses may be fit to certain valuation methods. A very good example of this is mature or asset-heavy companies, they are likely to benefit from an asset-based or DCF valuation, while high-growth technology start-ups may require a multiple-based analysis.

Make sure to assess the available data because it can have a huge impact on the choice of valuation. If you have limited financial information, methods like the P/E ratio or market transaction analysis will be more appropriate.

Are you interested in understanding more about your company’s value? Acquinox is an independent M&A advisor with a focus on technology companies. Get in touch with us today to find out more about how we can help you assess your company’s value and determine exit scenarios.

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