For public companies, an active trading market determines a company’s value. However, for private companies, there is no liquid auction market to daily attribute value to the company. For private companies, a market must be created in order to determine value.
Creating a Competitive Market Is the Only Way to Determine the Actual Maximum Value
In order to obtain the actual maximum value for your company, you must run a transaction process that generates interest among buyers and creates a competitive market. Correctly orchestrating a transaction process and creating a competitive market is one of the most important functions your investment banker provides. A well constructed market is composed of multiple qualified buyers. Just as with art, beauty is in the eye of the beholder when determining a company’s value – the buyer’s eye. Different buyers will have varying motivations about why they would like to buy your company and how much they are willing to pay. No valuation study or analysis can give you the actual market value of your company. Until you build a market and see buyers’ opinions of value firsthand, any preliminary valuation is simply an estimate.
Estimating Business Value Before a Sale
However, before commencing the sale of your company, one of the key factors you will want to determine is an estimated price range a buyer could pay for your business. It is important to go through the exercise of estimating the value of your company so you can have an idea of the prices you can expect and the underlying rationale for those prices. An investment banker or valuation specialist can assist you in this exercise. Before committing to undertake the process of selling a business, you need to be realistic about price. Otherwise, if your price expectations are out of line with the market, the process will be for naught and a significant waste of resources and time.
Businesses Are Valued On Earnings – Past and Future Expectations
Simply, businesses are valued and sold based on their ability to generate earnings. It is paramount for you to credibly demonstrate and clearly communicate both historical and future earnings of the company. Since most valuation methodologies are based on evaluating earning potential, much time and preparation should be spent in this endeavor.
Valuation Methods and Tools
There are a number of important tools and methods to help determine estimated value. By using these methods, you can derive a range of estimated values, which should approximate the actual value achieved through a company sale. Further, buyers will use the same methodologies, so it important to understand what goes into each. The following provides a brief description of the primary methodologies.
Earnings Based Approaches
Ultimately, buyers are concerned about future earnings. There are many methodologies, short-cuts and rules of thumb to determine value based on future earnings. The three primary methods are discounted cash flow, leveraged buyout and capitalization of earnings analyses.
- Discounted Cash Flow (DCF) Analysis. This method projects the expected earnings capacity and economic benefits of your business into the future, as viewed by the buyer, and uses a discount rate to derive a net present value today.
- Leveraged Buyout Analysis. This is akin to the discounted cash flow method and is used by private equity groups. By assuming a certain capital structure (debt and equity), projected earnings and rate of return hurdle, they calculate an implied value.
- Capitalization of Earnings. These methods include a myriad of valuation ratios: price to earnings, earnings before interest, taxes, depreciation and amortization (EBITDA) to enterprise value, price to cash flow, price to book value and the list goes on. Basically, these methods apply some factor to an earnings level to derive a valuation.
Market Based Approaches
The market provides an accurate predictor for price. You can obtain a sense of valuations by reviewing trading and transaction activity for both public and private companies. Note the valuation benchmarks use the earnings capitalization methods discussed previously.
- Comparable Publicly Traded Company Analysis. This method applies current market valuation metrics and ratios of publicly traded companies to a private company in order to imply the value. The public companies used in the analysis must be comparable in nature among themselves and to the seller’s business. Since the comparable public companies tend to be larger than the seller’s business and their securities are freely tradable in an open market, a discount generally ranging from 20% to 50% must be applied depending on the characteristics of the seller’s business.
- Precedent Merger and Acquisition (M&A) Transaction Analysis. This method takes a sample set of previously completed M&A transactions for companies that are similar in nature to the seller’s business. This sample set provides valuation benchmarks that can be applied to the seller’s company to derive a value.
Concluding Thoughts On Company Valuation
Estimating company valuation is more art than science. As a seller, it is important to establish your price expectations prior to embarking on a company sale. Additionally, a buyer’s purchase price is based as much on perception as fact. It is important to clearly present to the buyer credible historical financial information as well as demonstrate compelling future earnings potential for your company.