As many of you have heard, valuation is an art and not an exact science – apart from other things, one goes by their own story and beliefs while arriving at the valuation. The market does make some mistakes, but these mistakes are rectified overtime.
So, why does a company need to do valuation? This is the biggest question that may come to anyone’s mind. This can be because of multiple reasons – investors would want to know the company’s value, other stakeholders would like to know the company’s value, or there could be other legal and regulatory requirements for undertaking the valuation.
Coming to the valuation methods, there are several common methods that can be used to value a company, including intrinsic valuation/ discounted cash flow (DCF), comparable company analysis/relative valuation, asset-based valuation, and the contingent claim valuation.
The discounted cash flow (DCF) method is widely used method for valuing a company. It involves forecasting the company’s future cash flows and then discounting them back to present value using a required rate of return. This method thus takes into account the time value of money, as well as the company’s growth prospects and risk, as it entails factoring in the cash flow, growth rate, reinvestment rate, terminal value, reinvestment rate etc. The comparable company analysis entails comparing the company being valued to similar companies in the same industry. This method uses financial ratios and other metrics to determine the value of the company based on the values of similar companies. The asset-based method entails valuing the company based on the value of its assets, such as its cash, property, and equipment and is often used for companies having significant tangible assets but limited earnings or cash flow. The contingent claim valuation uses option pricing models to measure the value of assets that share option characteristics.
Considering that DCF and comparable company method are the most prominent methods, let’s discuss a bit more about it:
In this, mainly, companies project the revenue growth for future years, like for the current year, along with the determination of terminal period and terminal value. After taking into account certain adjustments, these values are discounted with the cost of capital to arrive at the Present value of the cash flows. Cost of capital involves a combination of two factors that is the cost of equity and the cost of debt – for determination of the cost of equity again; multiple factors need to be factored in like which sector the company is operating in, which countries companies are operating it, determination of the country risk premium – suppose a company is operating in three different countries, every country doesn’t has same market risk. The other thing that is very critical is the determination of reinvestment rate, where one has to decide how much reinvestment (i.e., how much of the earnings will be reinvested in the business back) would be.
Also, the valuation may have different results based on the purpose for which the valuation is done and the assumptions of the valuer. Let’s take an example – When someone is buying a company, they will always want to buy at a low price while the seller would want to sell at a higher price. Accordingly, when somebody is doing the valuation from the seller’s side, they will value the company more by building their own stories, while if someone is doing the valuation from the buyer’s side, their intent may be to value the company less.
And then the other important method that is often used or relatively easier method is relative valuation/ comparable company analysis. In comparable company analysis, generally people find the comparable company, say 20-30 companies in the same sector and gather certain data points around those companies – some data may be publicly available, also there are databases from which data can be extracted. Basis the available data or comparable company data, one may run some regression analysis, the result of which can be used to arrive at relative valuation.
Even in cases where DCF is used for valuation, comparable company method can be used as corroborative method. Further, scenario analysis can be performed to know the probable valuation based on variation of certain metrics and to simulate the results so that the story will make some sense from different angles.
Overall, the method used to value a company will depend on the specific circumstances of the company and the purpose of the valuation.
The valuation of private company often becomes difficult as there is no financial history, competitors or precedent transactions. Amongst others, following are certain points which are often seen while valuating a private company: Market trends for the product and segment, management team, cash-flows, trademarks and intangible assets. Also, start-ups and private companies may not have a track record of financial performance, making it difficult to forecast future cash flows and growth prospects. Additionally, start-ups and private companies may be subject to different market conditions and risks vis-a-vis public companies.
Thus, the biggest challenge for private companies is availability of requisite data for undertaking the valuation – for public company data is publicly available: one can find financials, also one can find multiple sources of gathering comparable companies data. But for private company, most of the data is not publicly available data, then many of them are always into low profit projection like low financial result, most of the startups are running in losses in initial years. So, these all things makes valuation of private companies more difficult.
Overall, valuing start-ups and private companies can be a complex and challenging task, and it is important to use appropriate methods and assumptions to ensure that the valuation is accurate and reflects the unique circumstances of the company.
One should be able to justify the valuation – considering the addressable market of the product segment, market position, regulation aspects (if it is a highly regulated segment), scalability prospects of business, customer acquisition cost etc.
Suppose a segment is hyper saturated and investor knows there are less chances of scalability as there is already much completion in the segment – if one does valuation by taking 20% growth rate in such segment without having concrete justification on such directional belief, investors in such cases would not believe in valuation. So one have to be mindful of numbers/ assumptions that is used in the valuation to avoid overstating/ misrepresenting the value of the company – it is important to be transparent. Overall, there should be:
Also, since startups may not be profitable in the initial years and the financials may not depict correct picture – investors in such cases will look at how scalable the company is (and may look more into the other dynamic side of the company like how much intangible e.g. user data). Even Facebook bought WhatsApp, a loss making company, at so high valuation just because of high user data and user base that WhatsApp has.
The metrics used to value digital businesses will depend on the specific circumstances of the business and the purpose of the valuation. It is important to carefully consider and select the appropriate metrics to ensure that the valuation is accurate and reflects the unique characteristics of the business. Some of the metrics used are mentioned below:
So one have to just check few metrics and see which one fits well for the company/ or specific segment of the company under valuation.
We see that data is not factored in directly in the financials or say in any metrics – tech companies relies mostly on data to attain competitive advantage and to shore up their competitive position in a wide variety of ways (by adding new value proposition/service offerings). Also, same data may have a different value for different users.
So, ‘How to value data’ – there are no concrete answers (traditional approaches of valuation alone may not work; though some form of stochastic approach, probabilistic or Shapley value may work)
Same goes for network effects which is not directly factored in the valuation. However, as mentioned no one takes into account directly network effect/ data in valuation – some may say that they are indirectly factoring it in the valuation. For ex. because of the network effects, number of user increasing and the revenue/ EBIT and growth projection is done for DCF taking into account the expected growth in the users. Same goes for data, there is no direct valuation system for data, nobody takes into account that and today every company is a data oriented business.
Further, return on investment is a common concept about which we have heard and is often used for as one of the performance metrics. But there is no concept of return on data. So, eventually if this concept of return of data builds up then companies will start including that into the performance matrix in the financial statement also and then there could be more transparency around this for the readers of the financial statement.
The views in all sections are personal views of the author.