How much is your company worth? Brief on business valuation
Before attempting to answer this question, let us recall or quickly learn the basics of the theory of finance.
Today's dollar is more expensive than tomorrow's , because the money that you have today, you can immediately invest and they "will go to growth," that is, will begin to bring interest. From this first principle, much of the theory and practice of finance grows.
Discount factor is the current value of 1 dollar received in the future. It is equal to the unit divided by the sum of the unit and the rate of return r:
')
The rate of return r is the reward that the investor requires for delaying the receipt of payments.
Future revenue embodies the forecast, but has no guarantees. The second principle of finance says: "A reliable dollar is more expensive than a risky one . " Revenue should be discounted by return on similar investments.
The project to develop new software is more risky than investment in bank deposits. Suppose, according to your estimates, the project is associated with the same risk as investing in shares of another software company traded on an exchange with an expected return of 20%. In this case, exactly 20% is the appropriate value of the opportunity cost of raising capital . This is exactly the profitability that you give up without investing money in securities that are comparable in risk to a project to develop a new software.
This circumstance can be misleading. A bank employee comes to you and says: “Your company is a well-established reliable enterprise, and you have few debts. Our bank is ready to lend you 100 thousand dollars necessary for the project at 12% per annum. ” Does this mean that the alternative return on equity for your project is 12%?
No, this is not true. Firstly, in this case the interest rate on the loan is not related to the risk of the project; it reflects only the well-being of your current business. Secondly, regardless of whether you take a loan or not, you still have to choose between a project with an expected return of only 15% and shares that are equivalent to the risk, but have an expected return of 20%. A financial manager who borrows money at 12% and invests them at 15% does not just stupidly, but desperately stupidly, if the company or its shareholders have the opportunity to get a loan at 12%, and invest with the same risk, but with yield of 20%. So what exactly the expected return on equity, equal to 20%, represents the opportunity cost of raising capital for the project.
One of the nice features of the present value is that it is expressed in current dollars - so you can summarize its values. Now we can determine the value of assets that create cash flows C1, C2, ... every year. Obviously, we can continue this series and find the present value of cash flows covering a variety of periods. It's simple:
The formula for calculating the net present value can be written as follows:
however, recall that C0, the cash flow in period 0 (today), is usually a negative value. In other words, C0 is an investment, cash outflow.
When making investment decisions, it is recommended to follow only two equivalent rules:
Why? Because these investments are better than alternatives in a market with this level of risk and return. Further, the book describes the objective advantages of using the NPV approach when making investment decisions with respect to other methods and many nuances of application in finance practice. In general, the knowledge gained may be enough to understand what we will talk about next - about the valuation of companies.
In total, the assessment distinguishes three main approaches:
Let's start with the cost approach (adjusted net assets method and residual value method). Applies to:
The meaning of the cost approach is to estimate how much it cost to create a company until today. The approach does not take into account the revenues that the company can generate in the future. It should be used only if it is impossible to predict the amount of such income. For a growing company, an unfairly low score is likely to be obtained without taking into account the uniqueness of technologies or skills of specialists working in the company and future business prospects.
The approach summarizes the costs that have already been incurred, which means that the appraiser operates with facts, not forecasts. The method is useful in that in the case of a growing business it allows you to get a reliable minimum estimate of its value, from which you can start.
The comparative (market) approach is simple and logical, but it is not always possible to use it. The approach is based on the principle of substitution. To compare the object of evaluation with peers, the appraiser chooses businesses with which he competes. Companies are selected according to criteria such as: affiliation to the industry, company size, type of products or services provided, life cycle stage, financial characteristics. If similar companies (or shares in them) were sold at such and such prices, then why not take their average value for a fair assessment, adapting this assessment to this particular business using simple coefficients that take into account scale and specificity.
The accuracy of determining the market value of the object is directly affected by the accuracy of the information on sales of analogues collected by the appraiser. Industry averages may not match the characteristics of your business, which may be better than its peers. This makes it possible to have a wide variation in ratings among stakeholders. An entrepreneur and an investor will have to prove to each other the correctness of their comparisons, of course, if they want to make a deal.
Finally, the income approach . For a better understanding of this particular method, we talked a little about the basics of corporate finance at the beginning of our article. For a startup that does not yet make a profit, but is very popular with customers or has developed a revolutionary unique product, valuation methods based on searching for an analogue or costing can be extremely unsuccessful.
When evaluating high-growth companies, start by thinking about what the industry and company might look like in the future. The future state should be a consequence of the indicators of operating activities, such as the level of market penetration, the average income per client, the return on invested capital. Predict when growth will slow to stabilize at the normal level of large companies.
The method is good and bad because it is very flexible and has no “hard” restrictions, because income forecasts are used, and the future is difficult to predict. Do not think that the method gives you the opportunity to "write a beautiful picture of the future of your business", for which the investor will be ready to give a lot of money. Any evaluation, which in this approach will be many, will be the subject of controversy. Excessive perseverance on his expert opinion about the value of any predicted values may lead to the investor rejection of the transaction. You may refuse and you will be right, if you do not give up the share or the whole business below its fair price, but it may happen that a highly valued business will have to be closed due to a lack of working capital.
Consider an example. A startup that develops a social mobile application for sharing reviews of geolocations, has just created a working prototype of its application and is looking for an investor to market.
According to the estimates of the founders, the total market volume is equal to 1 billion rubles of income per year. Their unique user incentive system will allow them to occupy 60% of the local market in 10 years. They need 1 million rubles for 5% of their company.
“Good,” says the investor. "Here is your net income forecast that you made yourself."
“In my practice, only 5% of the companies in which I invested at this stage of development become profitable and pay off also investments in the rest. There are about 100 such companies in my investment portfolio. It turns out that if I give each 1 million and only 5% pay off, for break-even I need profitability of successful startups at 2000%, and for total profitability 2500%. This will be an alternative rate of return or discount rate.
I think that your business today is worth 1.67 million, so I can give you 1 million for 60% of the company. Or your business should be shown how it differs from hundreds of other companies at the seed stage. When the risks of investing in a business (and the discount rate) fall, I can offer you better conditions. ”
Of course, the investor could ask a lot of questions about the reasons for the forecasts of the market volume, the company's market share and every other forecast. You, in turn, could question the chosen rate of alternative returns. When a business starts to bring real money, the risk level and discount rate are reduced to reasonable values, forecasts are based on current stable operating indicators and explosive growth is not expected, the income approach allows you to take into account many features of your business in assessing its value.
Whatever approach is chosen, you have a difficult path to compromise between the interests of the investor and yours. Many characteristics will create a large number of different options for assessing the value of the business, each of which will need to not only prove, but also choose the right buyer for this.
“The peculiarity of the living mind is that it only needs to see and hear a little in order for it to be able to think long and then understand a lot.” Jordano brunoHere is our express course, squeezed from a book by Richard Braley and Stuart Myers, Principles of Corporate Finance, respected by many financiers and investment analysts. We highly recommend reading to anyone who has ever had to make a decision on investing money.
Today's dollar is more expensive than tomorrow's , because the money that you have today, you can immediately invest and they "will go to growth," that is, will begin to bring interest. From this first principle, much of the theory and practice of finance grows.
Discount factor is the current value of 1 dollar received in the future. It is equal to the unit divided by the sum of the unit and the rate of return r:
')
The rate of return r is the reward that the investor requires for delaying the receipt of payments.
Future revenue embodies the forecast, but has no guarantees. The second principle of finance says: "A reliable dollar is more expensive than a risky one . " Revenue should be discounted by return on similar investments.
The project to develop new software is more risky than investment in bank deposits. Suppose, according to your estimates, the project is associated with the same risk as investing in shares of another software company traded on an exchange with an expected return of 20%. In this case, exactly 20% is the appropriate value of the opportunity cost of raising capital . This is exactly the profitability that you give up without investing money in securities that are comparable in risk to a project to develop a new software.
This circumstance can be misleading. A bank employee comes to you and says: “Your company is a well-established reliable enterprise, and you have few debts. Our bank is ready to lend you 100 thousand dollars necessary for the project at 12% per annum. ” Does this mean that the alternative return on equity for your project is 12%?
No, this is not true. Firstly, in this case the interest rate on the loan is not related to the risk of the project; it reflects only the well-being of your current business. Secondly, regardless of whether you take a loan or not, you still have to choose between a project with an expected return of only 15% and shares that are equivalent to the risk, but have an expected return of 20%. A financial manager who borrows money at 12% and invests them at 15% does not just stupidly, but desperately stupidly, if the company or its shareholders have the opportunity to get a loan at 12%, and invest with the same risk, but with yield of 20%. So what exactly the expected return on equity, equal to 20%, represents the opportunity cost of raising capital for the project.
One of the nice features of the present value is that it is expressed in current dollars - so you can summarize its values. Now we can determine the value of assets that create cash flows C1, C2, ... every year. Obviously, we can continue this series and find the present value of cash flows covering a variety of periods. It's simple:
The formula for calculating the net present value can be written as follows:
however, recall that C0, the cash flow in period 0 (today), is usually a negative value. In other words, C0 is an investment, cash outflow.
When making investment decisions, it is recommended to follow only two equivalent rules:
- Rule of return: to invest in any project, the yield of which exceeds the yield of equivalent risk investments in the capital market.
- Net present value rule: invest in any project with positive net present value. The latter is the difference between the discounted, or reduced, value of the future cash flow and the value of the initial investment.
Why? Because these investments are better than alternatives in a market with this level of risk and return. Further, the book describes the objective advantages of using the NPV approach when making investment decisions with respect to other methods and many nuances of application in finance practice. In general, the knowledge gained may be enough to understand what we will talk about next - about the valuation of companies.
In total, the assessment distinguishes three main approaches:
- Profitable
- Comparative
- Costly
Let's start with the cost approach (adjusted net assets method and residual value method). Applies to:
- to companies that can be created by other people in the same form and for the same time frame;
- to the business under liquidation;
- to the business is not yet generating income (sales have not yet been).
The meaning of the cost approach is to estimate how much it cost to create a company until today. The approach does not take into account the revenues that the company can generate in the future. It should be used only if it is impossible to predict the amount of such income. For a growing company, an unfairly low score is likely to be obtained without taking into account the uniqueness of technologies or skills of specialists working in the company and future business prospects.
The approach summarizes the costs that have already been incurred, which means that the appraiser operates with facts, not forecasts. The method is useful in that in the case of a growing business it allows you to get a reliable minimum estimate of its value, from which you can start.
The comparative (market) approach is simple and logical, but it is not always possible to use it. The approach is based on the principle of substitution. To compare the object of evaluation with peers, the appraiser chooses businesses with which he competes. Companies are selected according to criteria such as: affiliation to the industry, company size, type of products or services provided, life cycle stage, financial characteristics. If similar companies (or shares in them) were sold at such and such prices, then why not take their average value for a fair assessment, adapting this assessment to this particular business using simple coefficients that take into account scale and specificity.
The accuracy of determining the market value of the object is directly affected by the accuracy of the information on sales of analogues collected by the appraiser. Industry averages may not match the characteristics of your business, which may be better than its peers. This makes it possible to have a wide variation in ratings among stakeholders. An entrepreneur and an investor will have to prove to each other the correctness of their comparisons, of course, if they want to make a deal.
Finally, the income approach . For a better understanding of this particular method, we talked a little about the basics of corporate finance at the beginning of our article. For a startup that does not yet make a profit, but is very popular with customers or has developed a revolutionary unique product, valuation methods based on searching for an analogue or costing can be extremely unsuccessful.
When evaluating high-growth companies, start by thinking about what the industry and company might look like in the future. The future state should be a consequence of the indicators of operating activities, such as the level of market penetration, the average income per client, the return on invested capital. Predict when growth will slow to stabilize at the normal level of large companies.
The method is good and bad because it is very flexible and has no “hard” restrictions, because income forecasts are used, and the future is difficult to predict. Do not think that the method gives you the opportunity to "write a beautiful picture of the future of your business", for which the investor will be ready to give a lot of money. Any evaluation, which in this approach will be many, will be the subject of controversy. Excessive perseverance on his expert opinion about the value of any predicted values may lead to the investor rejection of the transaction. You may refuse and you will be right, if you do not give up the share or the whole business below its fair price, but it may happen that a highly valued business will have to be closed due to a lack of working capital.
Consider an example. A startup that develops a social mobile application for sharing reviews of geolocations, has just created a working prototype of its application and is looking for an investor to market.
According to the estimates of the founders, the total market volume is equal to 1 billion rubles of income per year. Their unique user incentive system will allow them to occupy 60% of the local market in 10 years. They need 1 million rubles for 5% of their company.
“Good,” says the investor. "Here is your net income forecast that you made yourself."
| Year | Net income |
| one | 40,000,000 |
| 2 | 80,000,000 |
| 3 | 160,000,000 |
| four | 240,000,000 |
| five | 320,000,000 |
| 6 | 384,000,000 |
| 7 | 460 800 000 |
| eight | 506 880 000 |
| 9 | 557,568,000 |
| ten | 613 324 800 |
| eleven | 674 657 280 |
| ... |
“In my practice, only 5% of the companies in which I invested at this stage of development become profitable and pay off also investments in the rest. There are about 100 such companies in my investment portfolio. It turns out that if I give each 1 million and only 5% pay off, for break-even I need profitability of successful startups at 2000%, and for total profitability 2500%. This will be an alternative rate of return or discount rate.
| Year (N) | Net income | Investments | Discount rate 1 / (1 + r) ^ N, where r = 2500% | Reduced Income (value today) |
| one | 40,000,000 | -1 000 000 | 0.0384615385 | 1,538,461.54 |
| 2 | 80,000,000 | 0,0014792899 | 118 343.20 | |
| 3 | 160,000,000 | 0,0000568958 | 9 103.32 | |
| four | 240,000,000 | 0,0000021883 | 525.19 | |
| five | 320,000,000 | 0,0000000842 | 26.93 | |
| 6 | 384,000,000 | 0,0000000032 | 1.24 | |
| 7 | 460 800 000 | 0,0000000001 | 0.06 | |
| eight | 506 880 000 | 0,0000000000 | 0.00 | |
| 9 | 557,568,000 | 0,0000000000 | 0.00 | |
| ten | 613 324 800 | 0,0000000000 | 0.00 | |
| eleven | 674 657 280 | 0,0000000000 | 0.00 | |
| ... | Total PV | 1,666,461 |
I think that your business today is worth 1.67 million, so I can give you 1 million for 60% of the company. Or your business should be shown how it differs from hundreds of other companies at the seed stage. When the risks of investing in a business (and the discount rate) fall, I can offer you better conditions. ”
Of course, the investor could ask a lot of questions about the reasons for the forecasts of the market volume, the company's market share and every other forecast. You, in turn, could question the chosen rate of alternative returns. When a business starts to bring real money, the risk level and discount rate are reduced to reasonable values, forecasts are based on current stable operating indicators and explosive growth is not expected, the income approach allows you to take into account many features of your business in assessing its value.
Whatever approach is chosen, you have a difficult path to compromise between the interests of the investor and yours. Many characteristics will create a large number of different options for assessing the value of the business, each of which will need to not only prove, but also choose the right buyer for this.
Source: https://habr.com/ru/post/333366/
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