Looking back at the first decade of the 21st century, you can see the investor psychology at work in setting the valuations of businesses and other income producing assets. Once the frenzy sets in, business valuations can rise to lofty levels rather quickly, at least in the short term. This is often driven by market comparisons: if one company sells for 10 times the gross revenues, then a similar firm should trade at about the same price. Sooner or later though any valuation runs into a reality check.
For example, take a look at the market approach. At any point in time, investors tend to compare the current prices of similar businesses to see what a given company is worth. And it can happen despite the fact that such prices may well fly in the face of historic reality. After all, how often have companies sold at 20 – 50 times their revenues? If you run across such a valuation, it is time for a reality check.
Investor excitement aside, your business valuation must pass two key tests:
- the market comparison should make sound financial sense
- and the business sale comps must be truly similar to the subject business.
One of the most accessible and reliable sources of business sales data is the public company transactions. These are usually available based on well established financial reporting standards and cover practically every industry sector. However, there is little comparison between a seasoned public company and an emerging start-up.
To make market comps work, you would need to consider a number of adjustments:
Company size risk premium
Smaller companies tend to be riskier. As a result, investors will demand higher returns to put their money into such firms.
Earnings track record
Start-ups with a limited track record are inherently more risky. Only future will show how successful the company is at executing its business plan.
Lack of marketability discount
Investments in private companies are essentially illiquid. This means considerable risk to the investors should they try to sell their shares of the business. Such lack of marketability can lead to considerable discounts on the company’s value.
Company specific risk premium
Private business owners are notoriously under-diversified. Their entire capital may be tied up in a single company. Unlike public company investors, owners of small to mid-size firms incur additional risks associated with the company itself. Examples are company capitalization, management team quality, market concentration and competitive position.
Reliable business valuation uses all three approaches
Your business appraisal should account for these factors to be defensible. To come up with a solid business valuation, consider using methods under all three approaches. Pick up an income-based method, such as the Discounted Cash Flow, to sanity check your market comparisons. Look at the asset base of the business using the Capitalized Excess Earnings method. This could be very valuable in cases where the company has built up considerable goodwill.
This combination of valuation methods may give you a range of business values. If your market comparison was based on sound reasoning, the income and asset based appraisal results should be close. If not, it is likely that the assumptions made in your business sales data selection or adjustments are the source of error.