How to determine what a company is worth:
1/ About Value
The first thing you need to understand about calculating the “value” of a company is:
It’s more art than science
The first thing you need to understand about calculating the “value” of a company is:
It’s more art than science
If you’re looking for a bulletproof method or one number to tell you the valuation of a company,
I’m sorry – it doesn’t exist
I’m sorry – it doesn’t exist
2/ The Art of Valuation
Why is it art?
Because the value of something is dependent on how much someone is willing to pay for it
Why is it art?
Because the value of something is dependent on how much someone is willing to pay for it
Let’s take a simple example:
A bottle of water costs $1.00 at a convenience store
But it costs $8.00 at a hot summer festival
A bottle of water costs $1.00 at a convenience store
But it costs $8.00 at a hot summer festival
It’s the same bottle of water. Why the different prices?
Because someone at a summer festival is willing to pay $8.00 because they really want that bottle of water
Therefore, value is highly influenced by human behavior and context
Because someone at a summer festival is willing to pay $8.00 because they really want that bottle of water
Therefore, value is highly influenced by human behavior and context
3/ Three Methods
There are 3 main valuation methods used to value a company
(This list is by no means exhaustive)
1. Comparable companies
2. Precedent transactions
3. Discounted Cash Flows
There are 3 main valuation methods used to value a company
(This list is by no means exhaustive)
1. Comparable companies
2. Precedent transactions
3. Discounted Cash Flows
Before, we cover each valuation method,
It’s important to understand one key aspect of deriving a valuation which is something called a “Valuation Multiple”
It’s important to understand one key aspect of deriving a valuation which is something called a “Valuation Multiple”
4/ What is a Valuation Multiple?
Valuations Multiples are best understood by looking at an example:
Let’s say ACME Inc.’s total company value is $200 million and its revenue for the past 12 months was $50 million
Valuations Multiples are best understood by looking at an example:
Let’s say ACME Inc.’s total company value is $200 million and its revenue for the past 12 months was $50 million
To calculate the ACME Inc.’s Valuation Multiple based on revenue,
You would divide the company’s Total Value by its Revenue:
$200 million / $50 million = 4
This means the company is worth 4 times its revenue for the past 12 months
You would divide the company’s Total Value by its Revenue:
$200 million / $50 million = 4
This means the company is worth 4 times its revenue for the past 12 months
Valuation multiples can be calculated for various measures of:
• Revenue
• EBITDA
• Earnings, and
• Operational metrics (ex. users)
With that covered, let’s get back to the 3 valuation methods
• Revenue
• EBITDA
• Earnings, and
• Operational metrics (ex. users)
With that covered, let’s get back to the 3 valuation methods
5/ Comparable companies
The comparable companies method of valuation is a “market based” approach for valuation
The comparable companies method of valuation is a “market based” approach for valuation
In this method, you calculate the Valuation Multiple for companies that are:
- in a similar industry to yours
- serve similar customers, and
- are of a similar size
- in a similar industry to yours
- serve similar customers, and
- are of a similar size
Let’s look at how this works via a simple example:
Let’s assume, you’re trying to sell your house
How do you know how much you should list it for?
Let’s assume, you’re trying to sell your house
How do you know how much you should list it for?
You would look at what prices houses similar to yours (in size and features) on your street are listed for
Based on those prices, you would come up with a price for your house
Based on those prices, you would come up with a price for your house
The comparable companies method of valuation works the same way
You calculate the Valuation Multiples for companies that are similar to yours
You calculate the Valuation Multiples for companies that are similar to yours
You do this by following these steps:
1. Find companies trading on the stock market similar to yours
2. Calculate their total value
3. Calculate their Valuation Multiples
1. Find companies trading on the stock market similar to yours
2. Calculate their total value
3. Calculate their Valuation Multiples
You then apply the Average or Median of these Valuation Multiples to:
Your company's Revenue or Earnings
This will give you a total value for your company
Your company's Revenue or Earnings
This will give you a total value for your company
6/ Precedent Transactions
This is another “market based” approach for valuation
In this method, you calculate the valuation multiple for companies that have been ACQUIRED that are:
- in a similar industry to yours
- serve similar customers, and
- are of a similar size
This is another “market based” approach for valuation
In this method, you calculate the valuation multiple for companies that have been ACQUIRED that are:
- in a similar industry to yours
- serve similar customers, and
- are of a similar size
If we go back to our real estate example,
Let’s say you’re trying to sell your house
How do you know how much you should list it for?
Let’s say you’re trying to sell your house
How do you know how much you should list it for?
You would look at what prices houses similar to yours on your street have been SOLD for (not listed)
Based on those SOLD prices, you’ll come up with a price for your house
Based on those SOLD prices, you’ll come up with a price for your house
The precedent transactions valuation method works the same way
You calculate valuation multiples for companies that were SOLD
You calculate valuation multiples for companies that were SOLD
You do this by following these steps:
1. Find companies that have been acquired/sold similar to yours
2. Determine how much they were sold for
3. Calculate their Valuation Multiples
1. Find companies that have been acquired/sold similar to yours
2. Determine how much they were sold for
3. Calculate their Valuation Multiples
You then apply the Average or Median of these Valuation Multiples to:
Your company's Revenue or Earnings
This would give you a total value for your company
Your company's Revenue or Earnings
This would give you a total value for your company
If you're thinking that the Comparables Companies and Precedent Transactions methods of valuation are similar,
You're right
You're right
The key difference is:
• Comparables companies:
You look at the value of companies in the stock market
• Precedent transactions:
You look at the value of companies sold/acquired
• Comparables companies:
You look at the value of companies in the stock market
• Precedent transactions:
You look at the value of companies sold/acquired
7/ Discounted Cash Flow
This method is not market-based and doesn’t use valuation multiples like the others do
This method is not market-based and doesn’t use valuation multiples like the others do
The discounted cash flow method of valuation is considered to be a calculation of the “intrinsic value” of a company
This is because it’s based on calculating how much money a company will make over the course of its lifetime
To calculate how much money a company will make over the course of its lifetime:
1) You will need to forecast the company’s free cash flow for a number of years, and
2) Then discount the future cash flows by a discount rate
1) You will need to forecast the company’s free cash flow for a number of years, and
2) Then discount the future cash flows by a discount rate
Future cash flows are discounted to account for
(i) the risk that the future cash flows may not materialize, and
(ii) to account for the fact that money today is worth more than money in the future
This is why it’s called “Discounted cash flow”
(i) the risk that the future cash flows may not materialize, and
(ii) to account for the fact that money today is worth more than money in the future
This is why it’s called “Discounted cash flow”
If we go back to our house example,
A discounted cash flow of your home would be calculated by:
Estimating how much cash your home could generate if it was rented
A discounted cash flow of your home would be calculated by:
Estimating how much cash your home could generate if it was rented
Based on the cash flows earned from rent over the lifetime of your home,
You would calculate its value using a discounted cash flow model
You would calculate its value using a discounted cash flow model
A major advantage of the discounted cash flow method of valuation is:
- it doesn’t rely on market valuation multiples
- it doesn’t rely on market valuation multiples
This is an advantage because:
Market multiples tend to swing too much on the high end or low end, based on movements in the stock market
Market multiples tend to swing too much on the high end or low end, based on movements in the stock market
The one disadvantage of using a discounted cash flow model is:
it’s based on a lot of assumptions and therefore prone to error
it’s based on a lot of assumptions and therefore prone to error
TL;DR
- Valuation is an art, not a science
- Calculate Valuation Multiples
- There are 2 market-based approaches
- (1) Comparable Companies
- (2) Precedent Transactions
- One Intrinsic approach:
- (1) Discounted Cash Flows (DCF)
- Valuation is an art, not a science
- Calculate Valuation Multiples
- There are 2 market-based approaches
- (1) Comparable Companies
- (2) Precedent Transactions
- One Intrinsic approach:
- (1) Discounted Cash Flows (DCF)
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