One of the most useful skills I’ve learned at college so far is the ability to quickly estimate the value of a business, or at least to have some idea of whether a valuation is correct. This is important in just about all fields – if you work in the private sector, putting a number on your business or that of your competitors is obviously crucial. But in other fields, for example public policy (my passion), many important funding decisions depend on assumptions about business valuations.
The best method for valuing a business depends on a number of factors, including its age, size, whether it is publicly traded, and so forth. In this article, I want to discuss three simple methods in common use, and discuss their pros and cons. Each one will probably give you a different result – part of the art of company valuation is using your gut as well.
For large, publicly traded companies, you can start by looking at the company’s market capitalization. This is simply the current share price multiplied by the number of outstanding shares. Put another way, it is the theoretical price you would have to pay to buy all shares in the company (even though you can’t generally acquire a public company this way in practice). Market capitalization is a good place to start because it provides a quick snapshot of how much investors are willing to pay for the company. This is done by simply looking at the share price – there is no need to make any assumptions about how a company will perform in the future.
The assumption baked into this method is that the future prospects of the company, and any other relevant information, are already reflected in the share price. This may or may not be true of course (recent craziness of stock markets around the world have made this pretty clear), but it’s a very good starting point.
Look at Similar Companies
For non-public companies and companies where there is little or no liquidity in the shares, we can no longer look simply at the price the market assigns to the company stock. In this case, one trick we can use is to search for recent sales of similar companies. What do we mean by similar? It depends. For example, if you are valuing a technology company that has only $5 million in revenue, and you can find other companies operating in the same sector with similar revenue that are valued at $100 million, you might make the case that the company has a similar valuation (in this case, $100 million). The idea is that similar companies in similar sectors have, broadly speaking, similar growth prospects.
This method, however, should be used with caution. No two companies are the same, and even if they look the same now they are unlikely to have identical prospects for the future. Intangibles like brand play a major part of company valuation, and are hard to quantify. However looking at similar companies is often a great starting point to give you a ballpark idea of the valuation of a company.
Discounted Cash Flows
A more formal and technical method of valuing a company is by computing its Discounted Cash Flows (DCF). This assumes that the company will be able to produce cash flows into the future, and then discounts those future cash flows back to the present day using a discount rate. This method is best when valuing companies that have reasonably predictable future cash flows, or at least when future cash flows can be grounded in market assumptions that are defensible.
There are several ways to compute Discounted Cash Flows. For starters, you can use the sum of the first few years of projected free cash flows, and then discount those back to the present. Alternatively, you can use a more advanced method, such as the Gordon Growth Model, which uses a more complex formula to account for the fact that a company’s growth tends to slow down over time.
Whatever method you use, Discounted Cash Flows is a powerful tool for valuing businesses. The key is to make sure that you have a strong understanding of the input assumptions about future cash flows and the discount rate used to discount the cash flows to the present. This is tricky, of course, since you don’t know the future cash flows of the business! But combined with other methods, this one often forms the basis for formal company valuations.
If you have the data and want to get an even more accurate estimate, you can also use an automated business valuation calculator that will apply tried-and-true formulas using more factors than you can compute manually yourself.
Remember the Goal
If you’re valuing a company, the truth is you’re probably doing it for a very specific reason. With this in mind, you should ask yourself which model is most appropriate. If you are trying to make the case for a large valuation based on future growth, and you think you can justify a high growth rate, you might use a model based on DCF with this growth rate factored in. If alternatively you are acquiring a company and trying to argue for a low valuation, you might be able to argue that it’s not worth much if you can find a similar company that recently sold cheaply. Company valuation is as much an art as it is a science.
The Bottom Line
As you’ve seen, there are many different ways to value a business, but they all serve the same purpose. The important thing is not to get too bogged down in the details. The reality is that most valuation methods are based on assumptions. As long as you can justify your assumptions, you can come close to the actual value of the business. If you are interested in learning more about business valuation, I recommend reading “Business Valuation: The Ultimate Guide to Business Valuation for Beginners” by Greg Shields as a good introduction.