Valuation Methods For Start-Ups – Importance, Types, Purpose
Have you ever wondered why there are different kinds of Valuation Methods for Start-Ups or established companies? If not, read this article to understand the importance of valuation and the types of methods used to evaluate a company’s performance. It is said so because it is crucial to know the impact of the valuation of a business as it lets the management make informed decisions for its growth. Not just the management, but even the investors pay attention to the methods implemented to evaluate a company’s worth to take necessary actions.
Valuation is a process used to determine the worth of an asset or company. It is useful to people related to the company for making decisions. Financial analysts, investors, business owners, and related stakeholders get benefitted from it. It focuses on the evaluation of a company’s financial health or impacts the sale and purchase of a company. Comparable company analysis is employed to find out the approximate value of a company. Different companies use different valuation techniques. Commonly implemented methods are discounted cash flow, market capitalization, asset-based valuation, PS ratio (Price to Sales Ratio), PBV ratio (Price to Book Value ratio), EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortisation), and PE ratio (price-to-earnings ratio).
It is applicable to companies that aim to measure their assets or equity’s value. Assets considered are both tangible and intangible like real estate, patents, intellectual property, trademarks, and inventory. Finance and investing entities view valuation as a key tool as it facilitates all kinds of stakeholders to make decisions as per the outcome.
Purpose of Valuation
Valuation has a key role in regard to business transactions. No wonder it is considered a critical and cardinal part of finance and business. The main goal of it is to lead investors toward making good investment decisions. This is being said because investors employ it for the evaluation of a company’s health and to figure out its potential growth. The usage of valuation techniques will allow the investors to identify company value; undervalued or overvalued. Once the investors are aware of the worth of a company they will make better decisions.
Valuation is applicable to companies that are about to merge, going public, or involving the sale and purchase of assets. These scenarios require the determination of the fair value of involved assets to ensure that both parties enter a fair deal which is done by a valuation method. Not just that, accurate valuation models are implemented to deal with financial reporting such as audits, annual reports, and adherence of procedure guidelines with accounting standards.
Accountability, decision-making, and transparency are the outcomes of accurate financial reporting obtained from the valuation of a company.
Classification of valuation methods
There are different approaches for different purposes. This means there is no single method that can be applied to every business/ Here is a list of generally implemented Valuation Methods for Start-Ups or established companies.
- Discounted cash flow method
- Asset-based valuation
- Market valuation method
- PE ratio (Price to Earning ratio)
- PS ratio (Price to Sales ratio)
- PBV ratio (Price to Book Value ratio)
Discounted Cash Flow Method:
This is an analysis that is used to determine the current value of the investment as per the estimations of the cash flows in the future. This kind of valuation method is helpful to entities that consider buying securities or acquiring a company. This is a tool that can assist managers and business owners in making decisions related to operating expenditure or capital budgeting.
A projected discounted rate is employed to attain the current value of expected future cash flows.
The main focus is on Net Asset Value (NAV) that can be obtained by subtraction liabilities from assets. Real estate, equipment, and inventory are considered assets besides other tangible items. The market value of a company’s liabilities and assets is taken to determine the value of the entity’s net asset value.
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Market Valuation Method:
The other name for this approach is the relative valuation method. It is commonly used to evaluate the value of stocks. This is done through a comparison between the worth of a company and related assets as per chosen metrics such as PS ratio, PBV ratio, PE ratio, etc. As all companies don’t have the same size, their ratios are considered to obtain an estimation of their performance. Another reason to use them is the various parameters they consider for stock valuation.
PE ratio (Price to Earning Ratio):
It is also known as the earning multiple or price multiple. It is a type of valuation method where the current stock price of a company is compared to its earnings per share(EPS). This valuation technique is commonly employed to find out the worth of publicly traded companies.
PS ratio (Price to Sales Ratio):
This valuation method compares a company’s revenues and stock price. The company’s stock price is divided by its underlying sales per share. If the obtained value is low, it is an indication that the company’s stock is undervalued. On the other hand, if the ratio is high, it means the stock is overvalued.
PBV ratio (Price to Book Value Ratio):
This is a conventional technique for valuing a company. A ratio that compares a company’s market value and book value is the Price-to-Book Value ratio. This is usually used to spot stock opportunities in financial entities like banks. A company may also use other methods such as EBITDA and PE ratio along with PBV ratio for its valuation.
EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation):
It is a technique applied to a potential sold business for determination of its worth. The business valuer or broker will take up the responsibility to value the company by using EBITDA. It is also used to calculate the return on investment (ROI) of a company.
Factors Influencing Valuation
The performance and worth of a company can be figured out using any of the above methods. The analysis requires certain inputs to produce an accurate result. Below are the common factors considered for the valuation of a company.
- Nature and history of business
- Business finances
- Economic conditions
- Intangible assets’ value
- Company’s management team
- Competitive landscape
Nature and History of Business:
The process of valuation needs every bit of information about the company from the beginning. The data needed for valuation is usually the company’s profits, losses, cash inflows, cash outflows, stagnation, growth, cost control, etc. Gathering all the relevant data will help in performing analysis to obtain accurate worth. The niche’s type, competition level and nature, and growth potential,e are other key factors considered.
Financial risk that can be calculated by using the value of liabilities, assets, and working capital. These are taken into consideration because the financial health of a business also affects its valuation. The amount of working capital required for the functioning of a company and making improvements in annual capital influence valuation along with the net worth, debt, and capital structure are other elements useful for valuation.
External factors such as economic conditions are important as much as internal finances. The risks associated with a business are calculated using its industry of operation and external current economic conditions. Competition in the industry and potential buyers interested in business are other external factors that get involved in the valuation process. It is also important to note that the worth of similar businesses can impact a company’s valuation. Macroeconomic factors like interest rates, GDP growth, and inflation impact valuation which is why they are taken as inputs. An organization that operates in a strong economy has a higher value compared to one that operates in a weak economy.
Intangible Assets’ Value:
The assets that are not tangible are considered for business valuation. A company’s goodwill, intellectual property, profitability, growth potential, and customer relationships are intangible assets.
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Company’s Management Team:
Every person who adds value to the business becomes part of its valuation process. Human resources in management are crucial assets for the company. Their involvement and contribution to the company’s success are accounted for in the valuation of a business. The experience of the staff along with their skills that accounted for running a business are key factors for valuation. Good governance practices and efficient management will attract higher valuations compared to weak and inefficient ones.
A business that operates in a market with higher competition will possess a lower valuation compared to one that has an edge over competition in the market. Industry outlook and trends are known to influence the valuation of a business. An entity that is part of an industry with positive growth aspects will have a better valuation compared to one that operates in a declining niche.
Valuation Methods for Start-Ups – Advantages
We have learned about the types of valuation methods and various factors considered for the same. Now is the time to know the range of benefits valuation brings to the company. Here are a few benefits of company valuation for your enlightenment.
- Tracking company’s progress
- Competitor benchmarking
- Creation of a plan for sale of a business
- Secures investment
- Management of tax transactions
- Resolves Buy-Sell Disputes
- Protects the value of business
- Enhancement of business performance
- Development of dividend policy
- Combines price and terms in market
- Helps in understanding the effect of business on its owner’s balance sheet
Tracks Company’s Progress:
Regular checks such as a review of the balance sheet to see that the value of assets is not lesser than liabilities are important. The availability of cash flow to pay staff and settle critical payments can be found if cash movements are done regularly. The integration of both elements is done to mitigate risk. The Price-to-earnings ratio and asset valuation can facilitate the same. A business valuer from a business valuation firm can perform Valuation Methods for Start-Ups post reviewing their overall health. On the other hand, a business transfer agent or business broker can offer valuation services to large businesses.
Professional brokers are skilled at gathering comparable data for business valuation and thereby mitigating the risk for an entity. The type of property, operational information, and sale value of similar businesses are used as filters to collect comparable data.
Setting a standard post collection and comparison of data of similar businesses as per the financial metrics and industry guidelines is referred to as benchmarking. Industry benchmarks let a business get a rank regarding its financial position, business performance, and market position. These let the management and concerned departments make crucial decisions like sales forecasting, accessing finance, and budgeting. The valuation report prepared by an analyst will give an unfiltered view of the business that includes weaknesses, growth potential, and strengths. This sheds light on hidden opportunities so that businesses can take appropriate actions to raise industry benchmarks.
Creation of a Plan for Sale of a Business:
Business valuation can be the first step to consider if a business owner is focused on selling their business in the future. This is said so because valuation methods can produce market value of an entity and the same can be used to price the business for sale. An analyst can prepare a valuation report for you to use as marketing collateral to grab the attention of the right buyers. Any founder who aims to increase the value of their business before selling it can utilize the valuation models to track its growth and make sure commercial targets are being met. Having a valuation form during negotiations with a buyer can help the potential seller identify if their business is being overvalued or undervalued.
A business valuation report will act as a supporting document for a company to get funds from investors and lenders. It allows the investors to choose the areas with scope for improvement and support the growth of a business. A business valuation report with a promising balance sheet, positive cash flow, and reliable turnover will attract investors as it portrays the company as an entity with low-risk investment opportunities.
Management of Tax Transactions:
Tax planning strategies are important to reduce the taxable income for any entity. Business valuation is one kind of tax planning strategy for a private business. For example, dealing with incentives processed to key executives can be shown as capital gains and not as income by implementing tax planning structures which are usually created depending on accurate valuations. Reduced gift and estate taxes that are associated with the sale or transfer of minority interests can be obtained by the valuation of business interests linked to minority interests.
Resolves Buy-Sell Disputes:
Believe it or not the Valuation Methods for Start-Ups are important as they have many parties that hold equity. Valuation techniques are key tools that can aid in establishing and executing a buy-sell agreement along with minimizing the probability of disputes. A valuation can be helpful to resolve any disputes that arise from a buy-sell agreement; the appraiser can use the valuation report to determine the authenticity of the sold value.
Protects the Value of Business:
As discussed earlier, a valuation report sheds light on the weaknesses of a company giving the business owners an opportunity to take necessary actions and mitigate the erosion of its value. In the same way, potential threats can also be identified through a valuation report to let the owners take steps to effectively meet the threats.
Enhancement of Business Performance:
Yearly valuation of a business can be used as a standard to assess its performance in terms of executing corporate strategic plans. Variations identified from the reports can be useful for shareholders to evaluate the management and propose appropriate changes. Annual variations display the performance metrics and ensure accountability.
Development of Dividend Policy:
A business has three options to deal with earnings; clear off outstanding debts, distribute dividends, and reinvest the earnings. As mentioned earlier, valuation facilitates the determination of return on investment (ROI). Once a company has this information handy, it can decide what to do with the earnings.
Combines Price and Terms in Market:
A well-developed valuation model can direct the business owner to see the strengths, threats, opportunities, and weaknesses of the company. This feature of a valuation method assists the management to make the best use of the company’s strengths and opportunities alongside mitigating the threats and improving weak areas. This indicates that the owner can set an appropriate price for the business to grab the best deal in the market.
Helps in Understanding the Effect of Business on Its Owner’s Balance Sheet:
Asset allocation is a key element in personal financial management. Regular valuation of the business identifies its worth and its impact on its owner’s portfolio. The largest asset on a business owner’s balance sheet is the private business interest. A strong valuation will direct the business owner toward making the right decisions regarding asset allocation and thereby reducing the risks related to the asset.
Courses That Can Make You an Analyst to Perform Valuation of a Company:
It is common for aspiring employees and business owners to get curious about business valuation. All such individuals or firms that aim to train their employees on Valuation Methods for Start-Ups can choose courses such as Equity research and valuation course, business valuation course, company valuation and Financial modeling course from established ed-techs and colleges.
FAQs on Valuation Methods for Start-Ups
Q. What are the commonly used existing Valuation Methods for Start-Ups?
Asset-based valuation, Market valuation method, PE ratio (Price to Earning ratio), PS ratio (Price to Sales ratio), PBV ratio (Price to Book Value ratio), and EBITDA are the prevalent Valuation Methods for Start-Ups and large corporations.
Q. Does the valuation of a business help its management to track its financial health?
Yes, because valuation is nothing but financial analysis carried out to understand the strengths and weaknesses of a business to make informed decisions.
Q. Do companies follow standard Valuation Methods for Start-Ups at the beginning of their journey?
No, different companies have different objectives, services, and operations. They choose valuation models as per their requirements.
Concluding thoughts on Valuation Methods for Start-Ups
Owning a business is easy compared to driving it toward success. Business valuation is a way to help companies find out their worth and make decisions to thrive in the industry. Investors and management both benefit from the Valuation Methods for Start-Ups or established entities as the company’s stakeholders can view the progress of the company to decide on being a part of the or not. On the other hand, management can create or develop strategies to fix the gaps in the business and promote its growth. Valuation tools assist business owners to identify their equity or asset’s value.
Stakeholders can figure out the company’s financial health and estimate its potential for growth and accordingly take action. Investors can use valuation as a tool to know if the company is undervalued or overvalued. Annual valuations are conducted to spot variations in the company’s performance. This practice of valuing a business is carried out in almost every corporation. However, it is a must activity for entities that are about to merge, going public, or involving the sale and purchase of assets. Analysis of the company’s performance and assets attracts outcomes like accountability, decision-making, and transparency for all parties associated with it.
There is a range of Valuation Methods for Start-Ups and settled companies. They are listed below
- Discounted cash flow method
- Asset-based valuation
- Market valuation method
- PE ratio (Price to Earning ratio)
- PS ratio (Price to Sales ratio)
- PBV ratio (Price to Book Value ratio)
The key reasons to follow a valuation method for a company are its ability to track the company’s progress, promote competitor benchmarking, create a plan for a business sale, secure the company’s investment, manage tax transactions, resolve Buy-Sell Disputes, protect entity’s value, enhance company’s performance, develop dividend policy, combines price and terms in market, help understand the effect of business on its owner’s balance sheet
The bottom line is knowing the worth of an organization is a key element as it promotes growth and attracts funds to maintain its stability in the industry. If you are keen on becoming an analyst who handles financial analysis or performs Valuation Methods for Start-Ups choose courses such as equity research and valuation course, business valuation course, company valuation and financial modeling course from established ed-techs and colleges.