Have you ever wondered how to determine what a business is worth? Perhaps you wish to get a sense of your own company’s valuation in anticipation of a capital raise or an upcoming sale. Or, maybe, you are thinking about acquiring another company. In either case, deciding how to value a business is tricky, even for professionals who do it all the time.
As a business owner, it can be helpful to understand how this works. Having coached many clients through this process, I will share some insights about valuation methods and how savvy investors incorporate additional factors when developing a company’s valuation.
Standard Methods of Valuation
The trouble with most business valuation methods is that there is no one-size-fits-all way to value a company. The process for evaluating the worth of a business can vary depending on its industry, target market, stage of growth, and countless other factors. Yet, it can still be useful to familiarize yourself with such methods because it will help you see how one might interpret a company’s financials. To that end, here are some standard techniques for calculating the value of a business based on quantitative information, along with their flaws:
Multiple of Revenue or Profitability
One way to get a sense of a company’s value is to look at its current revenue or a profitability metric like EBITDA (earnings before interest, taxes, depreciation, and amortization) and apply a “multiple.” Although this sounds simple in theory, some companies have no revenue or profitability metrics at all, and even for those that do, arriving at the appropriate multiple can be difficult. Therefore, this method only works in certain situations and often requires valuation expertise.
The Discounted Cash Flow Method
Another approach to determining a company’s value is to look at its future cash flow projections. Then, you apply a discount rate to calculate the net present value (NPV) of the company’s future worth (the company’s value in today’s dollars). However, first, you need to develop realistic projections. Then, you need to determine the appropriate discount rate (also known as the weighted average cost of capital (WACC)). Unfortunately, neither one of these tasks is easy, so while such insight would be helpful, it may require further investigation.
Market Cap (Market Capitalization)
For public companies, calculating market cap can be an easy way to estimate an organization’s value. Simply multiply the number of shares outstanding by their current market price to determine a valuation. However, this method doesn’t account for other factors that affect a company’s worth, such as the amount of debt on its books. Furthermore, if you run a private company and don’t know how much your shares are worth, this won’t be helpful. In this case, looking at similar competitors may be more telling.
As you can see, using standard valuation calculations to determine how to value a business isn’t wrong, per se. But some techniques don’t work for medium or small businesses, and they often leave too many questions unanswered.
When valuing a company, professional investors look at more than its income statement and balance sheet. They expect a complete set of financial reports detailing its future earnings potential, with realistic and achievable forecasts. They will also ask for insight into the company’s financial processes and controls to understand not just if it has been generating revenue and profit but how. This allows them to assess what is working, what isn’t, and whether they can replicate (and build upon) the organization’s success.
So, I recommend that you view the methods above as a starting point for assessing an opportunity. Such calculations can spark an honest internal discussion about what would make a transaction worthwhile to you. Then, look at the company through an investor’s lens by searching for problems to address and improvements that can boost value.
Applying an Investor’s View When Evaluating How Much a Business is Worth
Although clean financials provide some visibility into a company’s growth potential and are essential when evaluating an opportunity, they don’t tell the whole story. Certain risk factors or insights into a company’s unique value simply aren’t visible in this data. Therefore, professional investors will look at other factors when making an assessment. These additional factors fall into two key areas: a company’s overall health and growth potential.
Before investing in a business, investors try to understand the level of risk involved and whether the potential reward is worth the risks. In other words, they want to know about any problems that could inhibit their ability to take the company to the next level. Therefore, they will turn a keen eye to its management, customers, and infrastructure in their quest for answers. So, if you wish to assess your company or potential acquisition, here are a few things to think about:
What will happen to the management team after the transition? When I work with CEOs who wish to find an investor or buyer, I encourage them to consider this question carefully and then lay the framework for a smooth transition.
Hiring, structuring, incentivizing, and training a strong, reputable management team is a tremendous undertaking. That is why a top-notch team can command a premium. If, however, critical players (like the CEO) will ultimately leave the business, it is vital to be transparent and to plan.
When this is the case, documented goals, strategies, and processes, along with an investment in cross-training, can go a long way. Such measures will ensure that the company runs smoothly when those critical people depart. One way to think about this issue is to consider whether the CEO could take a 3-month (or longer) sabbatical while feeling confident that the company would continue to function without missing a beat. That’s the goal.
Naturally, we all want a balanced mix of customers who will deliver a reliable source of revenue, but most companies have some strengths and weaknesses in this area. For instance, if most of the company’s income comes from just a few customers or if the pricing model is volatile, investors will notice and ask questions. A desirable company will openly discuss such issues and develop plans to address them.
Investors also appreciate organizations that can demonstrate the value of their offering. For example, if a company claims to deliver excellent customer support or high-quality products, an investor will look for customer reviews or case studies as proof.
What people, processes, systems, policies, procedures, data, and reporting are in place to ensure that the business not only runs smoothly but can grow and scale? For instance:
- What are the plans to mitigate any supply chain problems that arise?
- Does the business own the real estate it needs to house people and equipment? If not, what happens if its lease expires?
- What are the company’s hiring practices, and how does it set expectations?
It is essential that management has thought these things through, knows where the vulnerabilities lie, and plans to deal with them.
Of course, when trying to determine how to value a business, investors look at way more than risk. They want to know the unique qualities that make a company a good bet. After all, they could build something themselves or seek alternative investment opportunities, so what makes a particular company appealing enough to move forward?
To get to the bottom of this question, it helps to step into the ideal investor’s shoes and ask, “what would be in it for them?” So, put on your investor’s hat and think about the following aspects of your company (or the company you are interested in) from this perspective:
Products and Services
Is the team passionate about what they do? Do they strive to gain a deep understanding of and compassion for their customers so they can make their products or services essential?
A strategic investor, who wishes to get involved with a company and build upon its work, will seek out these qualities. Such teams are motivated, disciplined, and focused. This makes it easier for a strategic investor to step in and work with them to move the company forward, significantly increasing their chances of getting a return on the investment.
A product roadmap and the team’s plans to make their offering more valuable or to branch out into new markets would also be attractive to such an investor. And they would want to know that the team understands the end game. In other words, the team should know how their plans will deliver a predictable and robust cash flow or improve profit margins.
Marketing strategies can vary dramatically from one industry to the next. Investors will want to know all about the company’s target audience and its plans to reach them and convert them into paying customers. They will ask what they have tried so far, what worked, what didn’t, and how they have shifted their strategies in response.
If, for instance, a company has a strong referral network, that’s great, but it shouldn’t be their only source of customers. What plans do they have to reach customers through other channels? And what systems have they developed for tracking and supporting customers throughout their journey with the brand?
How to Value a Business: Key Takeaways
Since every company is different, determining the value of a business is more complicated than one might think. Therefore, when assessing a company’s worth, investors look at a broad mix of factors, from its financials to its marketing plans and everything in between.
It can absolutely be helpful to do some internal estimations if you are thinking about selling your business, pursuing an investor, or acquiring another company, but don’t hesitate to ask for help. Someone with expertise in this area can save you a lot of time and heartache. They will help you set realistic targets, get organized, and pursue your goals with confidence.
If you would like to learn more about this topic, be sure to download our comprehensive guide, “What Investors Really Want,” for additional details.