In: Accounting
Discuss the process of determining a company’s value. Using formulas and specific examples (e.g., numbers) illustrate the process of company value calculation
The valuation of any company is determined on several factors.
First, what is the purpose? If it's for tax, stock option pricing, or reporting purposes, like for a 409a, it's advantageous to have the value a low as possible. Valuation appraisers use a number of different methods to determine the valuation: discounted cash flow, asset valuation, and Black Scholes are a few common ones. A higher valuation is useful for a couple of purposes. If it's for fundraising a higher valuation means smaller dilution. If it's for a sale, then the highest possible valuation is the best one to have.
For the sake of the rest of this answer, let's assume it's for a sale.
Second, the valuation of every company in a sale is calculated using the following formula:
V = P x M
V is the valuation
P is the Profit of the company. This is typically measured as
EBITDA. This can also be R for Revenue in the case of technology
companies.
M is the multiple determined by the industry.
A good company is valued at the industry average.
A company with issues is valued below average.
A company with strong strategic assets will be valued above
average.
So what causes a company to be valued below average? They have risk items that need to be addressed and the acquirer has to bear the burden. This is where PE firms make a fortune. They buy companies that need some financial engineering and then sell them a few years later for a nice return. These are items that you need to demonstrate you have in due diligence.
So what causes a company to be valued above average? Acquirers don't want to pay for synergies because if they're the ones making the synergies happen why would they pay the seller for them? But they will pay for certain strategic assets that they can leverage, like IP and time to market advantages. These are items you need to prove you have in due diligence.
Third, the valuation of a company depends on negotiation skills. What is the ability of the acquirer to make an acquisition? Does it have the capital? What is the ability of the seller to demonstrate it has strategic assets that are transferable to the acquirer? Is there a competitive bid situation?
Ultimately, the value of a company is determined when the transaction closes.