Basics of Business Valuation
Business valuations are rather considered as a work of art than science nowadays. Valuations of businesses having fair business prospects are now booming even if they are at a prototype stage only. The startup culture is growing at a rapid speed in India and shows like the shark tank has given flames to it. People have now learned a lot about the valuations of different businesses at different stages and most of them are shocked too after seeing such a high valuation of recently started startups.
Founders and general people also are not very much aware of the valuation principles and methodologies to value a business. Investors on the other hand are very much concerned about it before investing in any business.
The general public is also interested in the same before putting their money in any of the IPOs. Startup founders also want to value their business correctly to get the best funding deals. We will be discussing here the common methods and calculations which are used by professionals to value a startup.
Why is There a Need for Valuation?
- Business financing
- Mergers and acquisitions
- Slump sale of businesses
- Tax planning
- Investor exit share valuations
What are the Common Methods for Valuing a Business?
Market Capitalization Method
Market capitalization of the company can be calculated by multiplying the numbers of shares outstanding for a company by the market share value of that company. For example, a company is having 10 crores of outstanding shares on a particular date and the market value of one share is ₹ 27, then the market capitalization of that company will be ₹ 270 crores.
This valuation method is also used to differentiate the companies in terms of small-cap, mid-cap, and large-cap for investment purposes.
The drawback of this method is that sometimes the market value of the share does not represent what is the actual worth of the business. Share value can many times be undervalued or overvalued.
Revenue Multiple Method
It is a method to value a business on the basis of turnover/revenue generated by the business. A multiplier is derived to be multiplied by the turnover of the business to arrive at a valuation. The multiplier is often varied on the basis of the nature of the business and its future growth prospects. For example, a tech company may be valued with a higher multiplier as compared to a manufacturing company.
The drawback of this method is that with an increase in revenue of the company, there may not be an increase in profits too, which may result in wrong valuations.
Earnings Multiplier Methods
With this method, business is valued on the basis of earnings of a company for a period multiplied by the multiplier worked out. It is generally the price that an investor is ready to pay for a profit of ₹ 1 of the company. Earnings considered are generally the EBIT (Earnings before interest and tax of the company). Earnings are also adjusted for tax effects, noncash items, interest incomes, and expenses before valuation.
Book Value Method
Book value method values the business on the basis of the amount of shareholders’ equity in the financial statement. It is basically the total assets of the company less total liabilities. For businesses following going concern assumptions, the assets may be valued at fair value for valuation purposes while businesses on the verge of liquidation need to value the assets on a realizable basis for correct valuations.
Discounted Cash Flow Method
Discounted Cash Flow (DCF) method is used to value businesses on the basis of the present value of future cash flows of the business. It is also an earning-based model in which earning cash flows are discounted using a discount rate to arrive at the valuation. A discount rate is generally the weighted average cost of capital of the company. This method focuses on the time value of money for valuation purposes.