If you are considering an outside investment for your business or looking to put money into a promising company, business valuation is surely to be one of the key data points in your decision making.
Significant investments are usually made in order to achieve some strategic goals such as increasing the business revenues, entering a new market or developing the next generation products.
Business valuation – a forward-looking exercise
The value of the business is thus driven by its future earnings. It also depends on the level of risk the company is likely to face as it pursues its plans.
Perhaps the most widely used business valuation methods for investment purposes are the income-based discounting techniques. The best known of these is the Discounted Cash Flow method. It enables you to determine the business value today, known as the present value, based on three fundamental inputs:
- Future earnings forecast over some period of time, e.g. 5 years.
- Discount rate which captures the business risk.
- Long-term or terminal business value – or what the business will be worth at the end of the forecast period.
Savvy investors usually are very good at assessing the company’s prospects and risk. Since they consider a number of investment projects, they have an idea about the kind of return on investment they expect.
Put another way, they see the discount rate as the rate of return they require to become interested in a business investment.
Comparison of business value and investment – Net Present Value
One common technique these investors use is the Net Present Value calculation. It combines the Discounted Cash Flow business valuation with a direct comparison to the value of the proposed investment.
If the difference between the business value and the amount of investment is positive, the investment makes financial sense.
A special case is when the business value is equal to the investment value. The discount rate that makes this happen is known as the internal rate of return, or IRR for short. At this rate of return the business creates precisely the amount of value that justifies the investment.
Internal rate of return as a decision making tool
You can use the internal rate of return as a screening tool for a proposed investment.
If you are a business owner considering an outside investment, you should know both the amount of investment and the rate of return the investor expects. You can use the Net Present Value calculation to see if your business can grow in value to make the cut.
If you are thinking of investing in a company and have the size of investment in mind, then you can use the Net Present Value calculation to see if the business can create enough value to meet your required rate of return on investment.
Using Net Present Value in a number of what-if valuation scenarios
Time value of money can make a major difference here. You can run a number of scenarios with different cash-out assumptions. Is an early exit a better strategy than waiting longer as the business value grows? The Net Present Value calculation helps you make such important decisions in a precise, fact-based manner.
ValuAdder gives you a set of standard tools to determine the value of a business, structure an acquisition deal, and make sound investment decisions.