There are three traditional valuation methodologies utilized in determining the worth for a private company.
1. Discounted Cash Flow: The discounted cash flow method, or DCF, involves the building of a financial prediction model that projects the future anticipated revenues, profits, and cash flow of the business. This future expected cash flow is then discounted back to the present time at a determined interest rate to calculate the value of the business today. The DCF valuation methodology is wholly dependent on the quality and credibility of assumptions within it — assumptions regarding pricing, costs, customer attrition, headcount growth and a multitude of others — all significantly impact the end “cash” number of the model. DCF valuation models are, by their nature, assumed to be imperfect and inexact, and as such are judged based on the perceived quality and credibility of the assumptions therein.
2. Market Approach: The market-based approach to valuation of a private company is similar to that utilized in valuing a house — namely look at what similar companies are valued at or have sold for (either wholly or in part) in the recent past (appraisal via comparables). Appropriate comparables to utilize include both current market valuations of publicly traded comparable companies as well as valuations of recent investments in and/or recent acquisition of private comparable companies. Of course, in choosing comparables it is important to compare apples to apples, both in terms of types of business and well as in historical financial performance. Often, one can utilize a quick short-hand market approach via a revenue or earnings multiple comparison. A traditional shorthand in this regard is to say that small, private companies will, on average, sell for approximately 3 times (3x) trailing 12 months cash flow. Medium-sized and larger business tend to be valued at much higher multiples (Companies comprising the Dow Jones Industrial Average trade at a 14 x trailing twelve months multiple).
3. Asset-Based Approach.Utilized more in distress situations where whether a business will generate any future earnings is in doubt, the asset-based approach to valuation involves an appraisal of the value that would be received via an orderly liquidation of a business’s assets. Except in rare circumstances, the asset-based approach yields a significantly lower valuation number than either the discounted cash flow or market-based approaches above.
So how should you approach completing a valuation for your business? Of the three methodologies above, the DCF method is both the most difficult to undertake, as well as having the most value from both a strategic planning and forecasting standpoint. It is also an absolute necessity to do (and do extremely well) if there is any thought or plan to raise outside capital and/or sell all or part of a business in the near or intermediate term. Importantly note that all emerging companies seek to be valued on their growth prospects as opposed to their historical financial results. Quite simply, the more credibly and excitedly one communicates those growth prospects in both a financial projections model as well as a future business narrative, the greater the value of the business will be today.