Denna sida är också tillgänglig på Svenska.
Many business owners start looking at the valuation question when they are contacted by a potential buyer. Unfortunately, many questions come up that could have been prepared much earlier. By valuing your company, you can see where your company stands today, what you need to improve and get a basis for setting goals for the future.
There are several different types of valuation models. They all come with their advantages and disadvantages. It generally established that all models would produce the same results if applied consistently and without any limitations. However, since most models today contain a forecast for the future, the models are applied with certain limitations.
The limitations will reduce the level of accuracy in different ways, depending on the model. We have selected the three most common business valuation model categories and will discuss the implications of each business valuation model.
Direct cash flow models.
The models are based on the cash flow that leaves or enters the company. They can be both direct and indirect, i.e. the models focus directly on the cash flows to the shareholders or indirectly on the cash flows that the company generates from an operational perspective.
Consequently, models based on discounting dividends to shareholders are included in the company, but this only highlights how profits are distributed, not how value is created. However, the two perspectives are directly related to each other, which means that it does not matter from a valuation point of view which perspective you take. The focus here is on cash generation.
The best-known indirect cash flow model is the so-called free cash flow model. It is useful when you want to have a view of your current status of cash generation from your business and is the key to creating value. Theoretically, this is the core of most models, but in practice it is difficult. Cash flows often vary greatly over time, making them difficult to predict.
Relative valuation models.
Relative valuation models are based on comparisons with other companies in the same industry. By looking at similar companies and their values, these models attempt to analyze your company relative to others. Relative methods can then illustrate whether a company is overvalued or undervalued compared to similar companies.
But there can be risks with general calculations because the conditions for individual companies are different. It could be argued that it was the lack of critical thinking that led us to the financial crisis of 2008. Sometimes the market misvalues an entire industry and it is best to be aware of these risks.
To make a good valuation, the key figures that are compared should be roughly the same as the other companies in the comparison. This is why you should be careful about the conditions you choose. Performance measures that are defined in the same way across companies are a good place to start. But again the limitation is in the market itself. Because the economy changes over time, industry key figures from last year can be misleading when analyzing a company today.
Accounting-based valuation models
Valuation models that are based on accounting come from the cash flow models. They are processed and adapted so that it is possible to use accounting information directly in the model. Accounting models are based on the book value of assets and liabilities.
The models are dependent on the congruence principle, i.e. changes in the company’s equity can only be explained by net profit and transactions with the shareholders. The real advantage of these models is that they use the relationships between the three financial statements: the income statement, the balance sheet, and the cash flow statement. This is to indirectly derive cash flows at the same time as the income statement and balance sheet are used as input to the valuation itself. These models are usually called residual return models.
Residual income model.
This model focuses on the company’s ability to generate value-creating profits both in the short and long term. The model is derived from a dividend discount model and is fully comparable to traditional cash flow-based models such as the dividend discount model or the free cash flow model. The advantage of the model is that it directly utilizes the key figures for profitability and growth that are usually used in key figure analysis of companies, as described above.
The residual income model uses three main components to calculate the company’s value:
- Booked equity at the time of valuation.
- Value-creating profits from the time of valuation until the valuation horizon.
- A calculated horizon value based on long-term sustainable profitability and growth.
The basis for the business valuation is the book equity at the time of valuation. This is calculated based on equity at the latest available financial statement including the part of untaxed reserves that can be considered equity.
Value-creating profits are the profits that exceed the required return on equity that applies to the company. The required return on equity is usually expressed as a percentage and can be compared to the actual return on equity.
If the return on equity is greater than the required rate of return, value-enhancing profits are created for the company, which affects the valuation positively. Correspondingly, value-destroying results are created if the return on equity is lower than the return requirement.
The calculated horizon value assumes that the company has sustainable long-term profitability development. This stage is reached when the company has reached a stable position in the market. The horizon value is industry dependent.
Enterprise value (EV)
Enterprise value (EV) is a commonly used measure of the total market value of a company. EV is the sum of what a company is worth to all investors, i.e. to both shareholders and lenders. It can be considered the theoretical price to buy the entire business, that is, the price to buy all the shares and pay off its loans. EV is independent of the company’s capital structure and can therefore be used for companies with different capital structures. EV note of changes in the capital structure. If a company raises capital from existing or new owners, it leads to an increase in share value that is offset by an equal increase in liquid assets.
Corporate valuations in startups
The biggest challenge with business valuations in startups, i.e. early-stage companies without revenue, is that most valuation models rely on revenue and profit forecasts. However, there are a few startups that in the early stages meet or exceed their initial forecast. This means that quantitative valuation models often do not lead to a correct valuation.
The Berkus method.
The Berkus method tries to circumvent the problem by using both qualitative and quantitative factors to calculate the value based on five factors:
- The company’s business model (base value)
- Available prototype (reduces technical risk)
- Competence of management (reduce implementation risk)
- Strategic relationships (reduce market risk)
- Existing customers or first sale (reduce production risk)
The Berkus method is a simple estimate often used for tech startups. It’s a simple way to calculate the value, but because it doesn’t take the market into account, the method isn’t as comprehensive as some investors demand.
The scorecard model.
This is one of the more popular startup valuation methods often used by business angels. The method is based on the comparison with similar start-up companies in the early stages, adjustment for the median valuation of companies that have recently been financed in the same industry and with similar conditions, to then arrive at a so-called “pre-money valuation” of the company (the key is to the comparison must be made with companies at a similar stage of development).
To begin with, you determine the average valuation for start-up companies “pre-money” within the same industry. After gathering this information, it’s time to weigh the most important aspects that make your business unique and adjust accordingly.
Determining how the company stands against others in the same region with similar conditions is done by assessing the following factors:
Founding team and management (0-30%)
Founding team and management – value will vary dramatically depending on background and experience and how people in the founding team complement each other.
Potential target market (0-25%)
Market size – the bigger your potential market, the better. If there are leads that are ready to buy your product, that’s even better.
If you have expected income in the short term, it is significant for the valuation. On the other hand, if you don’t have any buying customers relatively quickly, the valuation will not be as high either. The finished product will still have value, but ideally, you have enough customers that investors will be able to see the potential for short-term revenue.
An assessment of the product’s unique conditions, and strengths/weaknesses against other alternatives on the market.
Entering a highly competitive market can be a risk. Then it is important that you can differentiate your offer from other alternatives on the market.
Marketing/Sales Channels/Partnerships (0-10%)
It is good to be able to demonstrate that the customer base is growing and that customers return regularly. An increasing customer base with loyal customers is positive for the valuation.
Need for additional investment (0-5%)
For many investors, the founding team is critical to success. If the business idea is unique and scalable, it only increases the value of the company.
Venture Capital (VC method)
The venture capital method (VC method), as the name suggests, is most often used in the venture capital industry and for valuing start-ups. The method is based on investors wanting to capitalize on their investment via an exit at some future date during the company’s life cycle. An investor will demand a return equal to a multiple of their initial investment or will seek to achieve a specific internal rate of return based on the level of risk in the company. The VC method discounts a future value attributable to the company. The future value of the company can be determined using any of the previously described methods, including the discounted cash flow or by using market multiples.
Using market multiples is the most common method of arriving at a terminal value, as a forecast of future cash flow at that point would be overly speculative. The parties will generally use a price/earnings ratio to calculate the terminal value. Once the terminal value is calculated, the post-money value is calculated by discounting (dividing by a discount factor) that represents the investor’s required return. The investor seeks a return based on some multiple of his initial investment. The investor can seek a return of 10x, 20x, 30x, etc., on his original investment at the time of exit.
The required multiple is based on the risk that the investor assesses in the company. The higher the risk, the higher the return required. If additional capital is required before an exit and the investor does not participate, dilution will occur after the issue.
One of the disadvantages of the VC method is that it is dependent on expected growth and future earnings. It is extremely difficult and speculative to calculate the company’s earnings at a future date. The VC method is based on valuation multiples to calculate a terminal valuation.