Skip to main content
Company valuation methods III: Quantitative methods
news

Company valuation methods III: Quantitative methods

By May 21, 2021June 2nd, 2022No Comments

To conclude this series on company valuation, we now explore the different quantitative methods used to value a business. Also, as a conclusion to this series of posts, we bring you some conclusions about these methods.

Company success readiness level

This is a proprietary methodology of GRECA that integrates our assessment scoring and the funds raised by the company, to determine the value of companies in early stages. The methodology takes the scoring obtained for the following indicators: Technology Readiness Level, Ream Readiness Level, Market Attractiveness Level, Business Readiness Level and Financial Stability Level. With the scores of these variables applies certain multiples to the funds raised by the company to determine a valuation of the company. As you can see, this methodology is a mix of qualitative and quantitative methods bringing in one algorithm both approaches to get the valuation. The reasoning behind this method is simple, the higher scoring in the COMPANY SUCCESS READINESS LEVEL, the better use of the funds raised by the team so, the valuation of the company shall be higher because the corresponding multiplier over funds raised shall be higher. This method gives a maximum value of the company of 20 times the funds raised and cero as a minimum.

Venture capital

The Venture Capital (VC) method is based on the fact that investors seek to achieve a specific internal rate or return (IRR) based upon the level of risk they perceive in the venture. On average, the VCs look for returns around 25%, but the level of risk perceived by any VC could be different, so the IRR required. The VC method incorporates this understanding and uses the relevant time frame to discount a future value attributable to the company. The time frame is around 5 years, that corresponds to the investment average maturing period of VC’s portfolios. On the other hand, the future value, that corresponds to the value of the company at the exit or disinvestment moment, can be determined by different methods, including the discounting cash flow, but VCs will likely use some multiple such as price earnings ratio or EBITDA multiple.

Summarizing, the method establishes the terminal value of the company at the disinvestment time and discounts this value at the desired IRR during the expected maturing period for the investment to calculate the post-money company value. To have the pre-money value it will only be necessary to discount the investment amount:

  • Terminal value = multiple x EBITDA
  • Postmoney value = (Terminal value) / (1+IRR)n
  • Premoney value = Postmoney value – Investment amount (premoney value is the value of the company before any investment from investors)

Where,

  • “Multiple” is the average market multiple price/EBITDA
  • IRR is the internal rate of return, around 25%,
  • n is the number of years expected to maintain the investment, around 5.

This method establishes the value in the future based on business forecasts and then establishes the value of the company as of today discounting the value in the future with the desired rate of return considered by the VCs. This rate of return, profitability, is very high because they assume they are investing in risky businesses, so they significantly reduce the future value to get the present one.

Discounted cash flow

Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to figure out the value of a company today, based on projections of how much money it will generate in the future. DCF analysis finds the present value of expected future cash flows using a discount rate.

When valuing a company, the weighted average cost of capital (WACC) is used as discount rate for estimated future cash flows. WACC is the average cost the company pays for capital from borrowing or selling equity.

For companies that continue on-going beyond the time frame employed for the forecasts, there is an additional value to consider named Terminal Value. Terminal Value (TV) determines the value of a business or project beyond the forecast period when future cash flows can be estimated. This allows financial models to value a company with a greater degree of accuracy. As such, TV often comprises a large percentage of the total assessed value. This is specifically relevant in start-ups.

There are two commonly used methods to calculate terminal value: “perpetual growth” (Gordon Growth Model) and “exit multiple”. The former assumes that a business will continue to generate cash flows at a constant rate forever while the latter assumes that a business will be sold for a multiple of some market metric.

DCF model is a powerful way of valuating companies that have predictable cash flows. Normally, this is not the case for start-ups that are, in general terms, still looking for their revenue models. But the DCF model suits perfectly the case of SMEs when they have historical data and forecasts built from them.

First chicago

This method is a direct consequence of multiple DCF scenarios, 3 generally, weighted under a single exercise to get a company valuation based on their individual forecasts and probabilities of occurrence.

Real options

This is a quantitative method that considers different strategic options that a company can have and that will produce different economic impacts. As this method integrates company’s rights to make chronological decisions in a capital project, the Real Options method increases the net present value of a company because a firm would not rationally exercise an option which lowers value. Real options analysis, as a discipline, extends from its application in corporate finance, to decision making under uncertainty in general, adapting the techniques developed for financial options to “real-life” decisions.

For example, R&D managers can use Real Options Valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects.

There are different calculation procedures, the most common ones are: Black-Sholes, binomial lattices, and specialized Monte-Carlo methods. Mathematical details of these methods have relevant complexity and cannot be covered in this blog.

Book value and liquidation value

For example, R&D managers can use Real Options Valuation to help them deal with various uncertainties in making decisions about the allocation of resources among R&D projects.

There are different calculation procedures, the most common ones are: Black-Sholes, binomial lattices, and specialized Monte-Carlo methods. Mathematical details of these methods have relevant complexity and cannot be covered in this blog.

Conclusions

There are many different methodologies to establish a company valuation and they will differ significantly in their results.
This is a logic consequence of the factors considered by each methodology. This can create confusion or lack of confidence in company owners, but they should understand that the perceived value of a company is very dependent on what potential investors may consider more relevant in their investment strategies. These methods give companies` owners clues on where their weaknesses and strengths are, and it is relevant to know these clues in advance when negotiating. Final price in a transaction will be always a consequence of company value but, also, many other factors related to the creation or not of a beauty parade scenario, the pressure of an investor to close a deal, the existence of other similar companies in the market and many other factors. To manage these complex situations, professional advisory may be relevant to maximize the result. It is true that investors will always ask to have direct relationship with entrepreneurs or companies’ owners, but a professional advise will always be helpful to deal with many tricky situations that appear during a transaction. GRECA’s professionals are experts on dealing with these complex processes to maximize transaction success and company’s prices.
Close Menu