How much is your company? Briefly about business valuation

    Before trying to answer this question, let's recall or quickly learn the basics of financial theory.
    “The peculiarity of a living mind is that it only needs to be seen and heard so that it can then reflect for a long time and understand a lot.” Giordano Bruno
    Here is our express course, squeezed from the book by Richard Braille and Stuart Myers, respected by many financiers and investment analysts, “Principles of Corporate Finance”. We highly recommend reading to anyone who has ever had to make a decision about investing money. Today’s dollar is more expensive than tomorrow’s , because the money you have today can be invested immediately and they will “grow”, that is, they will begin to bring in interest. From this first principle, much of the theory and practice of finance grows. The discount factor is the present value of $ 1 received in the future. It is equal to one divided by the sum of the unit and rate of return r:

    $ DF = 1 / (1 + r) $

    The rate of return r is the remuneration the investor requires for deferring payment.

    Future revenue embodies the forecast, but has no guarantees. The second principle of finance says: "A reliable dollar is more expensive than a risky one . " Revenue should be discounted on the return on a similar investment.

    A project to develop new software is riskier than investing in bank deposits. Suppose, according to your estimates, the project is associated with the same risk as investing in the shares of another software company, which are traded on the exchange with an expected return of 20%. In this case, it is 20% that is the appropriate value of the opportunity cost of raising capital . This is exactly the profitability that you refusewithout investing money in securities comparable in risk with a project for the development of new software.

    Such a circumstance may be misleading. A bank employee comes to you and says: “Your company is a well-established and reliable company, and you have few debts. Our bank is ready to lend you 100 thousand dollars needed for the project at 12% per annum. " Does this mean that the alternative return on capital for your project is 12%?

    No, this is not true. Firstly, in this case, the interest rate on the loan is not related to the risk of the project; it only reflects the well-being of your current business. Secondly, regardless of whether you take a loan or not, you still have to choose between a project with an expected return of only 15% and shares that are associated with equivalent risk, but at the same time have an expected return of 20%. A financial manager, borrowing money at 12% and investing it at 15%, is not only stupid, but desperately stupid if the company or its shareholders have the opportunity to get a loan at 12%, and invest with the same risk, but with yield of 20%. So it is the expected stock return of 20% that represents the opportunity cost of raising capital for the project.

    One of the nice features of the present value is that it is expressed in current dollars - so you can summarize its values. Now we can determine the value of assets generating cash flows C1, C2, ... every year. Obviously, we can continue this series and find the present value of cash flows covering many periods. It's simple:

    $ PV = C1 / (1 + r) + C2 / (1 + r) ^ 2 + C3 / (1 + r) ^ 3 + ... $

    The formula for calculating the net present value can be written as follows:

    $ NPV = C0 + C1 / (1 + r) + C2 / (1 + r) ^ 2 + C3 / (1 + r) ^ 3 + .. $

    we recall that C0, cash flow in period 0 (today), is usually a negative value. In other words, С0 is an investment, an outflow of funds.

    When making investment decisions, it is recommended that you follow only two equivalent rules:

    1. Rule of return: invest in any project whose profitability exceeds that of equivalent risk capital investments in the capital market.

    2. Rule of net present value: invest in any project with a positive net present value. The latter is the difference between the discounted or reduced present value of future cash flow and the amount of the initial investment.

    Why? Because these investments are better than alternatives in the market with such a level of risk and profitability. The book further describes the objective advantages of using the NPV approach when making investment decisions in relation to other methods and the many nuances of applying finance in practice. On the whole, the knowledge gained may be enough to understand what we will talk about later - about valuing companies.

    In total, three main approaches are distinguished in the assessment:

    1. Profitable
    2. Comparative
    3. Costly

    Let's start with the cost approach (adjusted net assets method and residual value method). It is applied in relation to:

    • to companies that can be created by other people in the same form and for the same time frame;
    • to business at the liquidation stage;
    • to a business that still does not generate revenue (there have not been sales yet).

    The meaning of the costly approach is to assess how much it cost to create a company to this day. The approach does not take into account the income that the company can generate in the future. It should be used only if it is impossible to predict the value of such income. For a growing company, an unfairly low rating is most likely to be received without taking into account the uniqueness of the technology or skills of specialists working in the company, and further business prospects.

    The approach summarizes the costs that have already been incurred, which means that the evaluator operates with facts, not forecasts. The method is useful in that in the case of a growing business it allows you to get a reliable minimum estimate of its value, from which you can build on.

    Comparative (market) approachsimple and logical, but not always possible to use. The approach is based on the principle of substitution. To compare the object of assessment with peers, the appraiser selects the businesses with which he competes. Companies are selected according to criteria such as: industry affiliation, company size, type of products or services provided, life cycle stage, financial characteristics. If similar companies (or shares in them) were sold at such prices, then why not take their average value for a fair assessment, adapting this assessment to this particular business using simple ratios that take into account scale and specificity.

    The accuracy of determining the market value of an object is directly affected by the reliability of the information collected by the appraiser on sales of analogues. Industry averages may not match the characteristics of your business, which may be better than peers. This makes it possible to have a wide range of assessments among stakeholders. The entrepreneur and investor will have to prove to each other the fidelity of their comparisons, of course, if they want to make a deal.

    Finally, the revenue approach. For a better understanding of this particular method, we talked a little about the basics of corporate finance at the beginning of our article. For a startup that is not yet profitable, but is very popular with customers or has developed a revolutionary unique product, valuation methods based on finding an analogue or calculating costs can be extremely unsuccessful.

    When evaluating companies with high growth rates, start by thinking about how the industry and company may look in the future. The future state should be a consequence of operational performance indicators, such as market penetration, average income per client, return on invested capital. Predict when growth will slow down before large companies stabilize at a normal level.

    The method is good and bad in that it is very flexible and does not have “hard” restrictions, as income forecasts are used, and the future is difficult to predict. Do not think that the method gives you the opportunity to "write a beautiful picture about the future of your business", for which the investor will be ready to give a lot of money. Any assessment, of which there will be many in this approach, will be the subject of debate. Excessive insistence on your expert opinion on the value of any forecast values ​​may lead to the refusal of the investor from the transaction. Perhaps you will refuse and be right without losing a share or the entire business below its fair price, but it may happen that a highly valued business will have to be closed due to a lack of working capital.

    Consider an example. The startup, which is developing a social mobile app for sharing feedback on geolocation, has just created a working prototype of its application and is looking for an investor to advance to the market.

    According to the founders, the total market volume is 1 billion rubles of income per year. Their unique user reward system will allow them to occupy 60% of the local market in 10 years. They need 1 million rubles for 5% of their company.

    “Good,” the investor says. "Here is your forecast for net income, which you yourself made."
    YearNet income
    6384 million
    10613 324 800
    eleven674 657 280

    “In my practice, only 5% of the companies in which I invested at this stage of development become profitable and also pay back the investments in the rest. My investment portfolio includes about 100 of these companies. It turns out that if I give each 1 million and only 5% pays off, for break-even I need the profitability of successful startups at the level of 2000%, and for the overall profitability of 2500%. This will be the alternative rate of return or discount rate.

    Year (N)Net incomeInvestmentsDiscount rate 1 / (1 + r) ^ N, where r = 2500%Presented income (value today)
    140,000,000-1 000 000 0.0384615385 1,538,461.54
    280,000,000  0,0014792899 118 343.20
    3160,000,000  0.0000568958 9 103.32
    4240,000,000  0.0000021883 525.19
    5320,000,000  0.0000000842 26.93
    6384 million  0.0000000032 1.24
    7460,800,000  0.0000000001 0.06
    8506,880,000  0.0000000000 0.00
    9557,568,000  0.0000000000 0.00
    10613 324 800  0.0000000000 0.00
    eleven674 657 280  0.0000000000 0.00
    ... Total PV 1,666,461

    I think that your business today is worth 1.67 million, so I can give you 1 million for 60% of the company. Or your business should show how it differs from hundreds of other companies at the seed stage. When the risks of investing in a business (and the discount rate) fall, I can offer you better conditions. "

    Of course, the investor could ask a lot of questions about the grounds for forecasts of the volume of the market, the company's market share and each other forecast. You, in turn, could question his chosen rate of alternative return. When a business begins to bring real money, the risk level and discount rate are reduced to reasonable values, forecasts are based on current stable operating indicators and explosive growth is not expected, the revenue approach allows you to take into account many features of your business in assessing its value.

    Whatever approach is chosen, you have a difficult path to compromise between the interests of the investor and yours. Many characteristics will create a large number of different options for assessing the value of the business, each of which will need to not only prove, but also choose the right buyer for this.

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