Valuation is the process of knowing how much money you will receive if you sell your company today.
--BY NEHAL PRANAMI
You own a company, continuously adding new assets, working day and night, expanding to reach its limit and making it a customer favourite. The company yields you revenue, sufficient enough to cover the company’s expenditures and satisfy your personal pocket. Now, suppose you attend a business conference where all the small and big entrepreneurs are present. “What’s the value of your company?” someone asks you. Is revenue or profit figures your correct answer?
Absolutely not. The value of the company is its current worth, not past revenues that you have earned. Valuation is the process of knowing how much money you will receive if you sell your company today. Or say, how much the market is willing to pay for your company.
“Valuation is not an exact science, but rather an art and a result of financial theories but more importantly of perception and negotiation,” says Prashant Pokharel, Director of Finance at Inspire Group of Companies, a group of startup companies from different industries.
Mergers, acquisitions and investments in businesses have become an everyday business for many, he mentions. And, without knowing the price of a mango, how much will you pay for it?
You may ask, “Why should I value my company if I don’t have any plan to dissolve or sell it ever? All I care is about how much profit my company is earning.” You may also think the valuation of a company to be only a time wasting task.
But, valuation grows other fruits too. It helps you to know where your company stands today, and moreover, where your company will be in the future. It helps you to know what the actual size of your company is. It further acts as a judging factor for an investor, to know whether investing in your company is worth it. Also, it is important to oneself to know how the market is looking at your company, i.e. whether it is undervalued or overvalued in the market.
“In this climate, where industries and businesses are looking for funding ever so often, knowing the value of your business or the value of any venture you are assessing to invest in is very important. The future success or failure of a company, in many ways, is based on how much thought is put into valuation,” states Pokharel.
There is no doubt that valuating a company is complex work. It can carry some element of manipulation too as valuation means predicting the future and the future is uncertain which makes it a little less reliable. But its importance offsets its drawbacks.
Depending on the nature of a business, a company is valued using different methods.
For manufacturing companies or those undergoing loss, assets based valuation method is the most suitable one. This method involves calculating the fair market value of the assets and subtracting the fair market value of liabilities from it. A company can have some unique assets as the key ingredient of the business and also some worthless assets previously costing a high price. Due to which, one must decide on which assets (including intangibles) or liabilities to consider while valuing and how to value them. If a company holds huge intangible assets, this method is less reliable as it can understate the intangibles like goodwill and copyright. Also, it doesn’t consider future changes in sales which can lead to undervaluation of the company if the company performs better in the future.
For early stage startups, relative valuation is favoured as they are better indicators of what the market is willing to pay for the startups. Relative Valuation (also referred as the house next door approach) is the method of valuing a company based on another company in the same business. Some valuation multiples like operating margins, price to book ratios and P/E ratios of other companies are determined and the firm is valued accordingly. It is useful for cyclical companies as well. It is the easiest and best method for IT companies too.
However, its major limitation is in assuming that the other companies might have been priced correctly by the market. Like assets based valuation, it is also based on a company’s past performance and future changes are not taken into account.
For a stable and mature company that pays regular dividends, the DCF method is most appropriate. Discounted Cash Flow (DCF) is the process of discounting the future cash flows of the company to find its present worth. The future cash flows are projected and discounted by opportunity cost i.e. a required rate of return.
The major advantage of this method is that it considers the future performance of a company, something which interests investors. It is not suitable if a proper prediction of the future is not done. If a firm is expected to produce less profit in the future, then the company is undervalued as future cash flows are valued less. Moreover, unseen future events can make the valuation completely invalid.
Experts say that, 99 percent of the time, Dividend Discount Model (DDM) is used to value banks.
Each of the above approaches assumes that the market makes some mistakes. So, depending on the purpose of valuation and inputs available, the best approach is selected to value a company. However, depending on only one method for valuation is like seeing with only one eye or even less, says Pokharel. A combination of two or more methods can also be done to get the best output.
“We, at our company, come up with a range of valuations for our company using various methods and then try to see which is the most suitable figure or even find an ‘average’ of the different methods. We mostly we DCF methods and Venture Capitalist (VC) methods of valuation,” shares Pokharel.
VC method is a popular method to value companies without financial statements or past records, i.e. startups. The company’s present worth is identified based on the exit value that a company is willing to pay if sold after some years. This Post Money Valuation is further subtracted with the invested amount by the company to calculate Pre-Money Valuation.