As your company continues to evolve and you focus more on growth, it is possible to lose track of a valuable data point – your company’s valuation, which is ultimately the valuation of your capital or total number of shares, and this data impacts your wealth.

Understanding and monitoring your business valuation is important. Typically, the time you need this information is when you are looking to issue new shares, sell or merge. The boardroom meeting with other shareholders, the talk with your banker, or other exceptional and unfortunate situations like an appointment with the divorce lawyers or a call from a tax controller are some likely scenarios where this discussion takes place. Beyond that, maybe you need to value your company every few years for audit purposes. Regardless of the circumstances, knowing your company’s worth is a must.

Taking it a step further, knowing the proper valuation metrics is also critical. Each company operates differently and needs a slightly different valuation methodology. To understand your company’s valuation, you need to understand widely used valuation approaches at a high level. From there, you can have a confident grasp of your company’s value.

Liquidation or Balance Sheet Approach

This method is very conservative and used by your creditors to protect their interests in case your business stops operations due to litigation, working capital shortage, recurring losses or any situation leading to bankruptcy. It consists of understanding the liquidity of your assets and assessing their value. For instance, your available cash is highly liquid; other instruments such as receivables are not as certain to be fully cashed in a timely manner and therefore less liquid. So, a discount on their value needs to be applied. We can also take the example of your inventory. While it may have a certain value on your balance sheet book value, the market value of the inventory may be lower (especially in a liquidation scenario).

Another approach to come up with a price floor is to calculate what it would cost to rebuild ex-nihilo the same business whilst acknowledging the time dimension.

While this will not likely be your preferred valuation method, it could provide you with the bottom line price which is important to know.

Discounted Cash Flow Approach

The Discounted Cash Flow method (or DCF) looks at the company’s future free cash flows (FCF), which are the estimated cashflows generated by your company to which debt- and equity stakeholders are entitled to after deducting all operating expenses, working capital effects and capital expenditures. This technique considers future cash flows, discounts them back to the present day – the present value of future streams of FCF, using the Weighted Average Cost of Capital (WACC).

Building out a DCF can be extremely complicated and many valuation firms have models in place to quickly help calculate a value. While it is not as important to know all the calculations, it is important to understand what goes into the calculations. There are some critical assumptions that would greatly impact future streams of FCF and they need to be documented.

The DCF methodology allows you to tweak certain scenarios. This is ideal for privately held companies that need to measure risk and future cash flows. The downside of using a DCF is that it is very dependent on the assumptions made. Therefore, assumptions need to be well considered and circumstantiated.

Trading Comparable Approach

This may go by a few slightly different names, but essentially, this approach values your company against others with a similar size and geography. Some data points considered include EBITDA multiples, price-to-earnings and so on.

An advantage to using this valuation methodology is that you are comparing your company to others in the current marketplace. However, depending on your size and market, finding data can be difficult. Many smaller companies are private, meaning they are not required to disclose their financials. Using larger listed comparable companies is an option if you use a marketability discount for the company and a liquidity discount for your shares.

Knowing the earnings multiple, you can go into a situation knowing how much your company is worth and if a willing buyer is paying the proper premium for your company. Also, you will know what other companies are worth – even if you receive an offer below your asking price, you can still be confident on how the market views comparable peers.

Precedent Transactions

Lastly, you can value your company using the Precedent Transaction Analysis. Similar to Comparable Analysis, this methodology compares your company against others ‘on-the-market’, that is, companies that are on sale or have been sold. (Companies not engaged in M&A are ‘off-the-market’.)

This type of valuation method is more likely used if your company is looking to engage in M&A activities. It will provide you with your company’s premium for being acquired, which is critical when identifying the proper price. The approach also considers data points such as EV/EBITDA, EV/EBIT and EV/Sales, and takes into account the M&A marketplace, whether it is a “buy” or “sell” market and therefore the dynamics in your ecosystem.

While this is not as widely used as the previous two methodologies and data may not be available, it gives you a perspective that other valuation methods may leave out, such as recent sales. When engaging an advisor to value your company, ensure they give you as many methodologies as possible.

How to Apply Different Valuations in Your Situation

It is important to note that valuation is more of an art than a science. To better illustrate the possible valuation of a company, we use a football field with the implied valuation range of each valuation methodology used, as shown in the following example.