It can be quite overwhelming looking at all the different options available. Comparing different methods can be confusing as some are relatively straight forward whilst others are complex, some focus on a company’s assets whilst others focus on earnings – so which offers the most reliable valuation? This is a question many startup founders find themselves faced with at some point and may use a business valuation approach that is not best suited to their company.

Why are Valuations carried out?

Company Valuations are carried out for several reasons; raising funds either through debt or equity would require a valuation of a company. When arranging a new loan, the company may need to prove that it will be able to meet the loan repayments and failing that, the lender will be able to use the assets of the company as collateral. When issuing shares, the company needs to know the value of each share to establish a share issue price.

For companies who drive growth through acquisition it’s vital to have an accurate valuation of the target company in order to determine a fair buying price. This is equally as important when selling a minority or controlling interest in a company. As well as deducing a fair selling price, it helps directors and shareholders understand the likely tax charge that will be levied on them from a disposal of shares and assets.

Other reasons a valuation might be carried out include establishing partner ownership, merging with another company, valuing for balance sheet purposes (particularly for intangible assets such as goodwill and brand), or simply carrying out a portfolio review.

Absolute Vs Relative

An “Absolute” valuation model attempts to find the intrinsic or “true” value of a company based only on fundamentals. This means focusing on things like dividends, cash flow and growth rate for a single company and not taking other companies into consideration. An example of models that fall into this category is the ‘discounted cash flow model’ which looks at the projected cash flows a company expects to generate in future years and discounts the values to find today’s present value. This method is specific to the company in question as it is based on its projected cashflows and growth rate.

A “Relative” valuation operates by comparing the company in question to other similar companies. This involves calculating multiples and ratios such as the price-to-earnings ratio which calculates the value of a company by measuring its share price relative to its earnings per share. This can then be benchmarked against other similar companies. Using this enterprise value calculation method, you would be able to see that if one company’s ratio was far lower than other similar companies, it may be considered undervalued.

In general, relative valuation is a lot easier and quicker than absolute valuation which is typically why many investors and analysts begin with this method.

Assets Vs Earnings

The biggest difference between an asset-based approach, and an earnings-based approach is that the latter method will give you an indication of how much value the company may generate in the future. The earning capability is more important to some investors, than the value a company holds today in its assets.

In many cases, it would be futile to use an asset-based approach, such as for a tech consulting company. A valuation produced from using a net asset approach may be low, and not representative of the company’s true value. The same method would produce a much higher value for a manufacturing company which has invested heavily in premises, machinery, and raw materials.

When using the earnings approach, it’s important to elect which measure of earnings to use throughout the process, whether its revenue, EBITDA or profit before tax.

Limitations of Valuations

So, what is the most reliable valuation method? The answer is there is not one correct method that should be used universally. Valuations are not an off-the-shelf product. Each company is unique and may have characteristics that require multiple methods to be carried out, which will inevitably produce different values. This will lead to some companies employing the method which produces the most favourable output for them. Others however may take a more measured approach and use an average of the values produced by multiple methods.

In any case, the value of the company will always be different to different parties, this is because valuation is in the eye of the beholder. For example, the founder of a company who has built it from ground up over several years will always value their company higher than any prospective buyer will.

The important thing is to be sure to use an enterprise value calculation method(s) that is best suited to your company, whilst trying to arrive at a fair value that all parties involved are satisfied with. Dragon Argent is here to help you navigate through the Enterprise Value Diagnostic process and if you are targeting raising equity investment in 2022, we discuss valuation as part of our Demystifying Venture Capital Whitepaper, which you can download here.