Explainer: Enterprise Valuation
Valuation and why it is important to you.
Before we dive into what valuation is and how to determine the valuation of an enterprise, let’s explore why it is important for enterprises and their founders. Valuation becomes really important when you are trying to raise money for your enterprise. To invest in an enterprise, investors will purchase shares (equity) in the entity. The value of this equity is a percentage of the overall value of the company.
For example, if a company is valued at $800,000 and needs to raise $200,000, investors will be seeking a 20% equity stake in the enterprise, at a fair exchange. This will then mean that the post-money valuation of the enterprise is $1m ($800k+200k).
Growing enterprises commonly require several funding rounds. In initial rounds a business can signal it is investment ready for future rounds when they show they can deliver sustainable revenues and growth. Each investment round should see an increase in valuation, reflecting the reduced uncertainty of future cash flows as the enterprise executes on its business plan.
Valuation – what is it? How do you determine value?
Valuation is a word we often hear in the news. Stock market valuation sometimes goes up and then sometimes goes down. Apple’s valuation is US$2.04trn, while Tesla’s is US$393.2bn. But those are listed examples. What about enterprises that are private and aren’t listed on a stock exchange? How do you value companies that are looking to raise capital? How do markets and investors determine the valuation of a private company or start-up?
In its simplest form, the valuation of a business can be understood as the intersection between what a buyer is willing to pay for the business and what a seller is willing to sell the business for. But of course, it’s a little more complicated than that in reality, so let’s explore the different factors and implications that go into thinking about valuation.
The value of a firm is given by all of the future cash flows that the firm will generate. When analysing future cash flows investors will consider several factors, including:
- Growth potential of those cash flows
- Risk profile of those cash flows
- Timeframe of those cash flows
- Potential additional investment requirements to generate future cash flows
For start-ups with little or no revenue or profits, and less-than-certain future cash flows, the job of assigning a valuation can be tricky. For mature, publicly listed businesses with steady revenues and earnings it is easier to form a view around valuation and there are several valuation methods which we will explore below.
Three Main Valuation Methods.
While there are many different possible techniques to arrive at the value of an enterprise - a lot of which are company, industry, growth stage or situation specific – there is a relatively small subset of generally accepted valuation techniques:
- Discounted Cash Flow Method (DCF)
- Comparable Projects and Proxies
- Business Current Asset Value
While these valuation techniques are easily the most commonly used, we do note that different businesses and industries utilise other approaches e.g. Cost-to-Duplicate analysis for a start-up with no revenue or a commodity reserves valuation approach for Metals and Mining companies.
Discounted Cash Flow Method
In its simplest terms, the Discounted Cash Flow Method states that a business is worth its potential future earnings to its owners. This valuation process determines the value of a business to its owners by estimating all expected future earnings of the business, discounted back to the present, and then summed up.
The rate that is used to discount future earnings is known as the cost of capital. The cost of capital for an established business raising capital for new investments is often 8-12%. For unlisted entities the rate may be significantly higher to reflect the increased risks and uncertainty around future cash flows not being delivered.
When thinking about the viability of an enterprises’ future cash flow, investors also consider additional factors:
- History of profitability or business achievements
- Experience of the management team and ability to execute
- Market size and potential market share for the company
- Intellectual Property (IP) or other highly competitive barrier advantages
- Stage of development of the business - idea vs. MVP vs. Scale
- Industry and company specific risk factors, such as competition or regulatory changes
- Composition of the capital structure (debt vs. equity)
Comparable Projects and Proxies.
Sometimes it is difficult to forecast future cash flows which makes using the Discounted Cash Flow Method quite challenging as a valuation method. With that in mind, investors can turn to proxies, comparable enterprises and comparable deal structures as a benchmark for valuation. They can compare the target enterprise to others in a similar context, using multiples of revenues, profits or other metrics.
The term ‘multiples’ refer to financial ratios used to review comparable business’ performance or strength. A common multiple used is the EV-to-EBITDA ratio (enterprise value – to – the earnings of the enterprise before interest, taxes, depreciation and amortisation).
In the simplest sense, if a company has a higher multiple it is indicative of either higher growth or more secure future earnings compared to comparable companies, and a lower multiple will suggest higher levels of uncertainty or risk relative to peers. Often times, the multiples method is used as an additional tool for investors to provide supporting contextual information to the discounted cash flows method.
Business Current Asset Value.
Business Current Asset Value or the ‘Cost Approach’ looks at what it costs to rebuild or replace an enterprise. It can be thought about as a company’s liquidation value is the total worth of all its physical assets, such as fixtures, equipment, inventory and real estate. This method excludes intangible assets, such as intellectual property, brand recognition and goodwill. If a company were to go out of business and sell all of its physical assets, the value of these assets would be the company’s liquidation value. The cost approach method is useful for valuing real estate, property, or an investment security, but it is not typically used to value a company that is a going concern.