Having spent the last 30 years as an investment banker, M&A advisor, board member, and CFO working with all sizes and types of companies and transactions, I frequently get asked by private company owners, “How much is my company worth?” Below I will outline the valuation process with the hope of helping you better understand that complex question.
In general, there are three main techniques used by thousands of valuation firms, investment bankers, Wall Street researchers, and business school finance professors to value a business. They are called different things by different people, so I will use the terminology I learned when I first started doing valuations.
For simplicity, let’s call that the company that is the subject of the valuation the “Target” and the party doing the valuation the “analyst” or “valuation firm.”
Comparable Companies
In the “Comparable Companies” methodology, the analyst’s goal is to find publicly traded companies that have similar characteristics as the Target. Characteristics could include industry, revenue, geography, customers, markets, etc. The analyst then compares the overall stock market value + debt (the “enterprise value”) of the comparable company to that company’s relevant financial metric (e.g., revenue, EBITDA, net income), resulting in a multiple of the financial metric (most commonly EBITDA) to the enterprise value of the comparable company.
Example: if a comparable company has a stock market value of $80mm and $20mm in debt then the enterprise value of a company is $100mm. If a recent 12-month EBITDA of the company is $10mm, then the EBITDA multiple for the company is 10x ($100/$10 = 10).
In the Comparable Companies method, like the Comparable Transactions method below, the analyst’s goal is to find as many comparable companies to the Target as possible - the larger the dataset, the better - without compromising the relevance and quality of the comparable companies. There is no hard and fast rule on what makes a company “comparable.” Nor is there a rule on the total number of comparables needed, but let’s assume 5-10 companies for now.
Once the analyst has a list of comparable companies, the next step is to collect the relevant financial information from those companies and create a set of valuation multiples. From that dataset, the analysts will eliminate the outliers and then look at the low to high range, average, and median multiples. Lastly, the analyst will apply the results of their analysis to the Target.
Example: Assuming the median EBITDA multiple for a set of seven comparable companies is 10x, the average is 9x and the range is between 7x and 13x. Assume also that the Target’s latest EBITDA is $5mm, then the potential values for Target are:
Median | $50mm (10x$5mm) |
Average | $45mm (9x$5mm) |
Range | $35-$65mm(7x$5mm & 13x$5mm) |
Comparable Transactions:
Similar to the Comparable Companies method above, in the Comparable Transactions method the analyst looks for data from publicly available data for recent sales or acquisitions of companies similar to the Target. This Mergers and Acquisitions (M&A) transactional information is available through public documents filed through the SEC (e.g., 8K’s 10k’s, etc.) and/or is gathered through other means (e.g., investor calls, new articles, etc.) Then, similar to the Comparable Companies method above, the analyst creates multiples of enterprise value from those transactions and applies those transaction multiples to the Target.
Example: Again, assume the Target has EBITDA of $5mm. Let’s assume the comparable transaction analysis comes up with ten recent comparable transactions with a median EBITDA multiple of 11x, and average of 12x, and a low to high range of 6-15x. The range of values for the Target using the Comparable Transactions method would be:
Median | $55mm (11x$5mm) |
Average | $60mm (12x$5mm) |
Range | $30-$75mm (6x$5mm & 15x$5mm) |
Discounted Cash Flow Method:
The next valuation method comes in various forms and can be called different things. I am lumping all of them under the generic term of “discounted cash flow” (aka DCF). In a DCF, the objective is to forecast the profitability / cash flow of the Target in the future (typically 3-5 years), assume a value of the Target at the end of that term (a “terminal value”), and discount all of the above back to today’s dollars using an appropriate discount rate.
There are volumes of financial textbooks written on the subject of DCFs. I will not address them here as the subject is too complicated. However, one thing to note is that DCFs are the backbone of how Wall Street investment firms value stocks. Wall Street looks at the future potential of a company and discounts that future potential back to today. DCFs are also how many VC firms or other investors value early-stage startup companies. The idea of looking at future potential earnings explains why companies that have no profit or cash flow can be valued for hundreds of millions or billions of dollars. (Think about Amazon in the early 2000s.)
Reconciling the Data (aka Averaging):
The last step in the valuation process is reconciling the data which I simply call “averaging.” Now that the analyst has three sets of data (comparable companies, comparable transactions, and DCF) resulting in many different potential values, what is the Target really worth? The true answer to this question is - whatever a buyer is will pay for it! A more technical or legal answer might be: what a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts, agree to the value of the Target.
However, the entire reason for a valuation in the first place is to answer the “how much is my company worth?” question prior to or in anticipation of taking the Target to market.
So what do most valuation firms do with the data they have collected? They review the underlying data, the outliers, the overall market, the resulting valuations, etc. based on their expertise. They then average the data, using some method of weighting the data as part of their proprietary process. They then come to a range of values for the Target.
Does this Work?
Hopefully, you now have a basic understanding of the valuation process. You may have noticed that there is a lot of “science” (i.e., math) to the process. But you may have also noticed that there is some “art” to it as well. By “art” I mean assumptions, creativity, hunches, etc. used in the valuation process. It’s not all science. For example, one valuation company's “proprietary” method of averaging will be different from another company’s, one company’s comparable sets will be different from another company’s, and one company’s terminal value and discount rate will be different from another company’s. To hammer home the point, two different people at the same company will likely make different assumptions and can therefore come up with different valuations for the same Target.
So the big question you may ask yourself is “do these methods work?” Given that most valuation companies use similar methods to value larger private or publicly traded companies, my general answer to the question is “yes these valuation methods work,” if for no other reason than if everyone is valuing companies the same way then they should all come to similar conclusions.
However, note that I said larger private or public companies above. For smaller private companies, I suggest you read another article I wrote called: Company Valuations in the Lower middle-market.
If you are interested in a valuation, a sale or strategic business consulting and are looking for an experienced advisor, please let me know. Thanks.
CEO and Founder of First CxO.
Bob Fiorella is a strategic problem solver, M&A advisor, and right-hand man to CEOs and business owners contemplating or dealing with a major change; whether it's restructuring a company, building a finance team, getting a loan, setting the company up for growth, successfully selling the company, etc. He began his career as an investment banker and worked on several deals including the multibillion-dollar merger of Avery and Dennison. Over the subsequent two decades, Bob’s career centered around the media, entertainment, packaged goods, wholesale distribution, specialty retail, technology, and software development industries where he took on roles such as SVP Finance, Chief Financial Officer, Chief Operating Officer, Chief Strategy Officer, and independent board member. Bob is the Founder and President of First CxO. Some of his assignments include being a fractional CFO for a $30mm packaging technology company, a $5mm software development company, and a $25mm e-commerce company. He is also an advisor to a $500mm franchising company. Bob holds a BS in Economics from Cornell University and an MBA from UCLA’s Anderson School of Management. Bob can be reached at 310-422-6858, bob@firstcxo.com.
Bob’s “claim to fame” is appearing on Season 13 of America’s Got Talent as part of the Angel City Chorale. They made it to the Semi-Finals.
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