Valuation Methodologies: The Pros and Cons

When it comes to valuing a business, there are several methodologies you could use, each with distinct advantages and disadvantages which make them more suited to certain scenarios.

Related: What is Business Valuation and Why Do We Need It?

If you’re not sure which approach to take, here’s an outline of the main business valuation methods available.

1. Discounted Cash Flow (DCF)

The DCF methodology is based on the premise that the value of a company is derived from the future cash flows it’s expected to produce. DCF methodology discounts these forecasted future cash flows to present value, taking into account the riskiness of that company’s estimated cash flows.

The Terminal Value is then calculated, which is the estimated present value of all of the cash flows (in perpetuity) beyond the forecast period. Free cash flows are calculated by deducting tax, cash required for working capital and capital expenditure from operational cash flow.

In terms offunding its operations, a business could use debt, such as taking out loans or offering long-term corporate bonds, or equity in the form of stock. Companies need to find a balance between these options that gives them the best possible cost of capital.

WACC is a measure of what these capital inputs or financing options will cost the company in terms of an average interest rate for the whole business. The weights refer to the different percentages that make up each type of financing in the company's capital structure.

Why is it important for a company to know its WACC?

Knowing your company’s WACC helps you estimate how expensive it will be to fund projects in the future.

For example, if it will cost an organization 7% in capital costs to fund a project that creates 10% in profit, then it can confidently raise capital to fund this project. If the project would only return 6%, it’s easy to argue against going ahead with the new project. Indeed, as a general rule, if a project returns more than a company’s WACC, it should pursue the project – so knowing your WACC is critical to strategic decision making.

The WACC formula is:

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

Where:

E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate

Here’s an example:
Imagine that a manufacturing business is thinking about building a new factory, for which it will need to raise $1 million in capital. The company knows that it can raise $800,000 from its bank at a 12% interest rate, but that the bank also requires an equity contribution from the company for the balance of $200,000. The shareholders of the company, who put $100,000 of equity in the company to start it up originally, are willing to inject this $200,000, but expect to earn a 25% return on their equity.

The company’s total market value is therefore ($100,000 original equity + $200 000 new equity + $800,000 debt) = $1.1 million. Assume its corporate tax rate is 35%. Now we have all the ingredients to calculate WACC:

WACC = (($300,000/$1,100,000) x 25%) + [(($800,000/$1,100,000) x 12%) * (1-35%))] = 0.12491 = 12.5%

The WACC is therefore 12.5%. This means that for every $1 the company raises under the capital structure above, it must pay its investors almost $0.13 in return. It also establishes a very useful threshold to inform the strategic decision to build a warehouse in the first place – unless the company believes the warehouse will generate returns above 12.5%, it should not build it (or, it should seek out cheaper sources of capital to reduce WACC).

Knowing your company’s WACC is therefore an important marker in justifying the potential costs of funding a new project. Not only that though – because it represents the cost (or "riskiness") of the company’s future cash flows, it importantly serves as the Discount Rate for DCF valuation purposes.

Pros of DCF:

  • It’s the most theoretically robust method of a business valuation (at EquityMaven, we use it as our primary valuation methodology).

Cons of DCF:

  • It assumes that the company being valued will survive and operate in perpetuity, but this assumption is not always correct for start-up companies for example.

2. Multiples

Similarly sized and spec’d houses in the same neighbourhood should have similar asking prices, should they not? The multiples approach is a theory of valuation based on this same concept: that similar assets sell at similar prices. The most common market approach makes use of the prices at which comparable public companies are trading, relative to their earnings, to imply comparable valuation multiples (these are often referred to as "Price-to-Earnings" or "P/E" ratios).

This method uses an enterprise value relative to earnings before interest, tax, depreciation and amortization (or EBITDA) ("EV/EBITDA") for comparable companies. These valuation multiples are then applied to the Sustainable EBITDA of the company being valued to derive a valuation. Sustainable EBITDA is used in the calculation to remove the effect of once-off items which are not expected to reoccur.

The difference between the DCF and EV/EBITDA valuations will come down to differences in forecasted cash flow growth rates between the company being valued and the industry comparable companies used in the EV/EBITDA valuation. For the smaller privately-owned companies it serves, EquityMaven uses Enterprise Value relative to earnings before interest, tax, depreciation and amortization (EBITDA) for comparable companies to perform its valuation calculations. These EV/EBITDA multiples are applied to the Sustainable EBITDA of the company being valued, in order to derive a business valuation.

Here’s a worked example to explain the EV/EBITDA multiple valuation approach:

  1. The first step is to calculate the sustainable EBITDA for the last twelve months for the company being valued. Assume this is $20,000 for the purposes of this example.
  2. Sustainable EBITDA is the EBITDA after subtracting any earnings and adding back any expenses that are once-off in nature. Going forward, this will give a more "normalised" picture of what the company EBITDA is expected to be.
  3. Next, an appropriate valuation multiple must be applied to the Sustainable EBITDA to result in an Enterprise Value for the company being valued.
  4. An appropriate valuation multiple is calculated by looking at other firms that are comparable to the company being valued and that are listed on public stock exchanges (and/or other known private transactions). The comparable company Enterprise Values are divided by their respective EBITDAs over the last 12-month period to arrive at EV/EBITDA ratios (or "multiples") for each comparable company.
  5. A median of these comparable EV/EBITDA ratios is then calculated and applied to the trailing twelve-month sustainable EBITDA of the company being valued, to result in the Enterprise Value.
  6. Excess cash is then added, and interest-bearing debt subtracted from the Enterprise Value to calculate the Equity Value.
  7. An illiquidity discount is then applied if the company is privately held.

It’s important to note that this type of EV/EBITDA multiple valuation can only be performed if the EBITDA for the company being valued is positive. Here are the workings:

EV/EBITDA valuation workings
Pictured: EV/EBITDA valuation workings

Pros:

  • Well understood by the public.
  • More externally verifiable, as it relies on market multiples of comparable companies.
  • Does not rely on detailed financial forecasts which can take owners a lot of time to complete – so valuations can be performed faster

Cons:

  • It can be extremely difficult to find truly comparable companies with similar growth prospects.
  • It also assumes that the company being valued will survive and operate in perpetuity.

3. Venture Capital Method

Valuing young companies is a difficult task. Because a new company is early on in its lifecycle, it can be hard to project what it will be worth in future – especially when it has no established products or services yet.

In his paper, "Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges", New York University Professor Aswath Damodaran outlines the methodology he uses for early stage start-up valuations, as well as the challenges:

  1. No history: History usually plays an important part in any regular valuation. Some new companies, however, may only have a year or two of data available. You therefore have to rely heavily on the user’s financial forecasts into the future.
  2. Many don’t survive: Young companies are risky, and many don’t survive the first year or two. This is backed up by several studies including Knaup and Piazza (2005, 2008) which used data from the US Bureau of Labor Statistics’ Quarterly Census of Employment and Wages (QCEW) to compute survival information on nearly 9 million US businesses. Between 1998 and 2005, only 44% of the businesses surveyed made it to four years, and only 31% made it through all seven years.
  3. Investments are not liquid: Since equity investments in young firms tend to be privately held and in non-standardised units, they are also much more illiquid than investments in public companies.

Taking the above into account, the Venture Capital method calculates a Terminal Value at a future date, when a venture capital investor assumes that they’ll be able to exit the investment. The Terminal Value is then discounted by the rate of return (over the period to exit) required by a venture capital investor.

The rates of return typically required by venture capital investors vary, depending on the stage of development of the company being valued.

Pros:

  • It enables early stage "pre-revenue" companies to be valued (because it’s easier to estimate a potential exit value at a future point in time, rather than estimating the cash flows prior to that point).
  • The discount rate incorporates the fact that the company being valued is not liquid and has a relatively high risk of failure. Further illiquidity discounts and survival probability weightings are therefore not needed.

Cons:

  • The method is typically used as a quick, indicative valuation only, and is not ideal if you’re looking for a really comprehensive or defendable valuation.

4. Liquidation Value

Liquidation Value assumes that the value of a company is equal to the price that would be received if a company’s assets were to be sold on auction, less the third-party liabilities of the company.

Related: Sale of Business Assets Agreement Template

Pros:

  • Most appropriate methodology for liquidation scenarios

Cons:

  • Most inappropriate methodology for firms that are stable and assumed to continue as a going concern

Knowing the right valuation method to use in the specific scenario you find yourselves in is key – so you can get the most accurate and defendable figure to use in your negotiations.



Published by ExitAdviser |

Content ID: 8541