You don’t need to be a financial modeling expert to be a great consultant. Yet, it’s still helpful to know the basic ways to value a business. After all, your goal is to increase the value of a business through your projects. Having some knowledge about the most common business valuation methods is useful. They can help you quantify the current and future value of the clients you serve. This will only increase your value as a consultant.
The steps to finding your business valuation depends on the method chosen, and the size of the company. Small businesses that are private and are just starting to generate revenue require different valuation methods than when valuing large, established public companies. Read on for the five most common business valuation methods.
5 Business Valuation Methods Consultants Use
These following 5 business valuation methods are merely an overview. If you’re required to find a client’s business value, more research may be warranted.
Market capitalization, also known as equity value, may the simplest of all business valuation methods. Your market capitalization is calculated by multiplying a company’s share price by its total number of shares outstanding. Market capitalization can only be calculated for public companies, as private companies don’t have a price per share.
For example, let’s say you are valuing Company A, which is currently trading at $70.00 per share and has 1 million shares. Company A’s market capitalization is simply $70.00 x 1 million, which equals $70 million.
Asset valuation is a business valuation method that is calculated based on the value of the assets and liabilities in a business. Essentially, the asset valuation is the remaining value when all the relevant assets are sold and all debts are repaid. Common assets include equipment, machinery, and properties. The asset valuation method is generally utilized when a company has a large number of assets. It’s also used when its long-term revenue generating capabilities are limited or difficult to predict.
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Trading Comparables Analysis
Trading comparables analysis, also known as trading comps, is a business valuation method in which you compare a company to its closest competitors that are usually trading in the public markets. With trading comps, you typically use ratios based on a company’s overall value (i.e. equity value or enterprise value) divided by operating financial metrics (i.e. revenue, EBIT, EBITDA, net income). This results in ratios, also known as multiples, that you apply to the company you are valuing.
For example, imagine you are trying to value Company A, which earns $15 million in revenue each year. Company A’s closest competitors have the following metrics:
- Company B – Enterprise value of $100 million and revenue of $20 million
Implies revenue multiple of 5x ($100 million / $20 million)
- Company C – Enterprise value of $200 million and revenue of $50 million
Implies revenue multiple of 4x ($200 million / $50 million)
- Company D – Enterprise value of $150 million and revenue of $50 million
Implies revenue multiple of 3x ($150 million / $50 million)
- Company B – Enterprise value of $100 million and revenue of $20 million
The average revenue multiple of these competitors is 4x. Given that Company A’s revenue is $20 million, this implies that your company’s enterprise value is $80 million (4 x $20 million).
Advantage of the Trading Comparables Analysis method:
One of the biggest advantages of using trading comps is that you are comparing against companies that are currently trading in the market. This provides your valuation perspective with an up-to-date valuation since the value of public companies change on a daily basis based on investor sentiment.
Precedent Transactions Analysis
Precedent transaction analysis, also known as transaction comps, is a business valuation method similar to trading comps. However, instead of comparing against companies that are currently operating, transaction comps use ratios and multiples to compare against similar companies that have already been acquired in the past. These multiples also typically include company’s overall value (i.e. equity value or enterprise value). You divide that by operating financial metrics (i.e. revenue, EBIT, EBITDA, net income).
Advantage of the Precedent Transactions Analysis method:
The main advantage of using transaction comps is that you are able to use multiples that previous acquirers have been willing to pay in the past. As an analogy, imagine you were trying to sell a bicycle. Wouldn’t it be comforting to know at what prices similar bicycles have been sold for in the past? The same is true with transaction comps.
Discounted Cash Flow Analysis
The Discounted Cash Flow (DCF) analysis measures the intrinsic value of a company. You base company value on its present value of future free cash flows. The DCF implies that a company’s value is essentially the sum of all the cash it is able to produce from now until the end of time. However, this future cash needs to be discounted back to present value because of a concept known as the time value of money. This concept explains that money today is worth more than money at any point in the future because one could use that capital to invest and receive a return.
To complete the DCF analysis, you first need to project out free cash flow (usually for 5-10 years) by making assumptions on the company’s revenue growth, margins, and a few cash flow line items (mainly depreciation and amortization, capital expenditures, and change in net working capital). Next, you calculate what’s known as the terminal value, which is the sum of all your future free cash flow from your last projected year until the end of time. Lastly, you discount back your projected free cash flow and terminal value using a discount rate, usually your WACC (weighted average cost of capital). This gets you to your company’s valuation.
Advantages of the Discounted Cash Flow Analysis:
The main advantage of the DCF analysis is that the person building the model is able to work in assumptions that he or she believes are true. For example, a startup would have no cashflow or assets to be able to use the other methods. This contrasts to the other aforementioned business valuation methodologies, which are determined by the market. However, this also means that these assumptions need to be scrutinized; otherwise, your valuation will be inconsistent when compared against other methods. This method is little more involved, but just having a basic familiarity with it is good.
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Business valuation isn’t a primary task of management consultants. Yet, having a basic understanding of how businesses are valued and steps to finding a business valuation will only add to your skillset and business acumen. It could come into play if your team is tasked to determine if buying a competing company is a good idea. It would be important to understand if the other company’s asking price is inflated or at value. Happy calculating!