New Venture Lab: Equipping Christian Entrepreneurs

Question

What are all the different ways of valuing a company?

Answer

There are several rules of thumb to employ when valuing an enterprise.  It is important to stress that these are guides to be used to initiate discussions only, since much of the valuation process is an art form, with the true value teased out through a process of rigorous due diligence.

 

Revenue Multiple - this will generally set the upper limit on a acquisition price.  It is rare that a company is worth more than 1X (read "one times") revenue.  Example:  A company experiences gross revenue of $1 million, the value of that company is not likely to exceed $1 million except in rare circumstances.

 

Earnings Multiple - this is closely tied to the revenue multiplier and is often set by industry based on average industry profitability.  Using average returns of 20%, then, a net income, cash flow or EBITDA multiplier of five would seem appropriate as a value gauge.  Example:  A company experiences earnings of $200,000, the value of that company using a net income multiplier of 5X would be $1 million.

 

Net Tangible Book Value - this is the asset angle of valuing an enterprise.  Net tangible book value needs to be calculated based on the company balance sheet (no two of which are alike) but simply stated, would be equal to all tangible assets (things like cash, inventory, written-down assets, accounts receivable, etc.) minus all liabilities and debt.  Example:  A company balance sheet shows total tangible assets of $2,500,000 and total liabilities of $1,500,000, the net tangible book value would be $1,000,000.

 

Net Present Value of Cash Flow - this is perhaps the best rule of thumb measure to use since most would agree that cash is king and it the best determiner of the on-going value of an enterprise.  Cash flow should be projected for at least five years and discounted at the purchasers cost of capital to determine the value to the purchaser.  Cash flow should be discounted at the seller's cost of capital to determine the value to the seller and at the buyer's cost of capital to determine the value to the buyer.  Example:  A company has experienced a cash flow of $100,000 for the last three years and has no major changes expected for the near future.  The NPV of the companies cash flow for the next five years based on a discount rate of 10% can easily be calculated on a financial calculator or computer, or can be calculated as follows:

 

            Year one                      100,000 X (1/1.10)  =             90,909

            Year two                     100,000 X (1/1.10)² =             82,645

            Year three                   100,000 X (1/1.10)³ =             75,131

            Year four                     100,000 X (1/1.10)⁴ =             68,301

            Year five                     100,000 X (1/1.10)⁵ =             62,092

            Total Five Year NPV of cash flow =                          379,078

 

One should add a terminal value to the stream of cash flows following the fifth year.  This terminal value might be the estimate of the company salvage value or a best guess as an on-going cash flow into perpetuity.  In the event that one wants to value the stream of cash flows in perpetuity, the formula is simplified as follows:

           

            NPV=Cash/rate

           

            In the above example, the value of the cash flow of $100,000 in perpetuity is $100,000/10% = $1 million