What is Valuation?
Quite simply, valuation is the outcome of a process and set of procedures that is used to determine what a business is worth. Business values can be affected by the perspectives of owners, investors, economic conditions, industry circumstances, the regulatory environment and many other factors deemed important by the business’s various constituents.
Valuation is an integral part of an effective pitch deck.
Common Valuation Methodologies
- DCF: The most common way to value a company, the valuation is derived by calculating the Net Present Value (NPV) of the Free Cash Flows (FCF) to arrive at either the Adjusted Present Value (APV) or the Weighted Average Cost of Capital (WACC)
- Pro: One can take future cash flows of a business and discount them back to arrive at an accurate current value.
- Con: Future cash flows are based on assumptions.
- Comparable: One can look at similar companies that the market has valued in a merger or an acquisition and examine these transactions to determine the key valuation parameter. Once that is determined, valuation may be obtained by applying previously executed deal metrics to the potential investment.
- Pro: This provides an accurate ‘market value’ for a similar company
- Con: It does not account for any specific or extenuating circumstances
- Multiple: This method is used quite often for equity valuation as it offers a yield comparison with other asset classes. A price/earnings multiple, inverted, offers a yield number that can be compared to the same on a debt instrument after accounting for the associated risk premium. Other multiple methodologies include Price/Sales, Price/Earnings/Growth, Price/EBITDA, etc.
- Pro: This provides standardization across companies by connecting their ‘earnings’ to their valuations
- Con: Comparing private companies to public companies may not always yield accurate results, as comparables are not yet mature. This also doesn’t account for intangibles such as brand value
- Market: The cornerstone of this methodology is born of the basic tenets of economics – supply and demand. The intersection of these determines the value of the company, and market values of publicly traded companies that are engaged in identical commercial activities can form the basis for a defensible valuation of an organization.
- Pro: It helps establish the value the market is willing to bear
- Con: Market valuations follow economic cycles and as a result are more prone to fluctuation
While there is no perfect way to establish business value, a thorough valuation exercise would utilize several of the methods above to triangulate back to a defensible conclusion.
We are in danger of valuing most highly those things we can measure most accurately, which means that we are often precisely wrong rather than approximately right. Valuation is an integral part of an effective pitch deck.