Common Methods for Valuing Companies

Beyond these general considerations, there are some some specific methods that investors use to value companies:

  • Discounted Cash Flow. Discounted cash flow (DCF) measures future intrinsic value. Since DCF looks toward future earnings rather than historical earnings, it’s particularly effective for early-stage businesses. DCF analyzes future free cash flows discounted by the weighted average cost of capital. In order to be useful, DCF should analyze future revenue models, not future revenue projections. Many investors will scoff at revenue projections, especially for early-stage businesses. Although DCF sounds complex, it’s rather straightforward. It simply estimates how investment funds will affect your future cash flows while discounting the time value of money. After running the DCF analysis, if the future price of your company’s shares is higher than the current share price, it’s deemed an attractive investment. If the future price of your company’s shares is lower than the current share price, it’s an unattractive investment.
  • Multiple of EBITDA (Earnings). Many early-stage companies are valued as a multiple of their operating income or what is often referred to as EBITDA – which is earnings before interest, taxes, depreciation and amortization. Considerations:
    • Why EBITDA. The notion is that EBITDA represents the normal operating income of the business when non-ordinary and non-operating activities (like depreciation) are removed.
    • Applying a Multiple. Investors apply a “multiple” and multiply that by the EBITDA. to determine the value of the enterprise. For example, if a multiple of 4X is used for a company that has EBITDA of $5 million, the value of the company would be $20 million.
    • What Multiple. These multiple ranges can be very wide, and vary substantially, within and between industries. As a rough ball park, assume EBITDA multiples can range from 3x to 10x, depending on your “story”.
    • Growth is Key. And, forecasted earnings growth is typically the #1 driver of your valuation (e.g., a 25% annual net income grower may see a 25x net income multiple, and a 10% annual net income grower may see a 10x multiple). In other words, the higher the growth projected and the sexiness of the industry, the higher the multiple will be.

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  • Multiple of Revenue. If there are no earnings yet, with your business plowing profits into long term growth, then revenue multiples or some other metric would be used. Revenue multiples for established businesses are typically in the 0.5x-1x range, but in extreme scenarios, can get as high as 10x for high flying companies with explosive growth (e.g., Groupon). But, that is, by far, the exception to the rule. And, if there are no revenues for your business, unless you are a bio tech business waiting for FDA approval or some new mobile app grabbing immediate market share before others, as examples, raising funds for your business, at any valuation, will be very difficult. Investors need some initial proof of concept to get their attention.

Valuation is a complicated concept. Creating a compelling business is the key but understanding the factors that impact valuation and how investors value companies should give you a foundation to better understand the process.

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