Can you actually put a price on something that changes as quickly as businesses?

The answer is…yes!

But before we do that, we need to talk about the underlying valuation principles and lay down a framework for valuing businesses.

To understand the valuation of a company we first have to identify what the definition of the term “company” is.

The definition I like the most is one that comes from the Italian Civil Law – “a group of assets organized by the entrepreneur to generate outputs that are larger than inputs” (I am Italian ;)).

Liquidation Value

The asset value method of calculating the price of a company stems from the above definition. According to it, the lowest value of a company should be the sum of the values at which we can sell the single assets.

Why the lowest?

If working organized assets are worth less than the same assets sold individually, the company is not doing a good job. In an economic sense, those assets are better off under another owner. This value is called the liquidation value.

Company Value

Also following the same definition, we have that the company value is the value of its organized and functioning assets. How to compute this value?

Let’s think about a company that has just one asset that can increase the value of the input: an ice maker. The asset filled with water produces ice cubes and then we sell the ice cubes. How much would you pay for that asset?

Economic principles say you would buy it if the value of all the cash that can be generated by that asset in the future is slightly higher than the price you pay today. Simply put, the price you pay today should be equal to your personal value of all the future cash that can be generated by the asset.

Now we have a problem. The cash flows are in the future while the price we have to pay is calculated as of today. It has to be determined today and can be paid just once. How can we compare future cash flows with a cash amount today?

Time Value Of Money

From a finance perspective we can argue that we can discount future cash flows to make them comparable to a certain amount today. The concept of the changing value in relation to time is called the time value of money.

This theory argues that if you can decide between having a dollar today and having the same dollar in one year, you would choose to take it now. This happens not just because of inflation, but also because we can use it now and exploit its benefits for a longer time, thus the reason for a discount. The one dollar after one year is not worth a dollar today, it is worth less.

How much less? It has to be discounted by the appropriate discount factor. This discount factor varies according to the risk of getting the dollar, to the period we have to wait and to a whole lot of other factors that are outside of the purpose of this article.

Multiple Valuation

Now you have the intuition behind the second main method to value a company, future cash flows need to be discounted to get at the price we are going to pay today.  This method is called the Discounted Cash flow and is the most used by professionals.

Another method takes into account that you will not pay much more or less for one egg than for another. If the price is too high compared to all the other eggs at the supermarket, you will just buy the others. If it’s too low, you will think that something is wrong with it. This method is called the Multiple Valuation and is based on the comparison of similar companies to determine the fair valuation of a company.

Each company should have a price (a value) that is close to other comparable companies based on the most common parameters like earnings, revenues or book value.

The specific procedure is calculating the average ratio for a group of comparable companies and then multiplying the same ratio for the specific metric of your company.

For example, you take the average value/revenues ratio for similar companies and multiply it by the revenues of your company.  That way you arrive at a value that is comparable to the value that was paid for a similar company. This adds credibility to your calculations.

There are of course other methods to value a company and there are specific applications of these methods (even combined) to value startups. However, the intentions behind the different methods are the same ones explained in this article.

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It is important to have these intuitions clear before digging into data, discount rates, forecasts and balance sheets.

Follow-up questions:

  • What is the best method to use in the case of your company?
    ·         How reliable is a valuation? Do we really have a price for a company?
    ·         Are there other methods to specific to startups?
    ·         How should we adjust the DCF to account for high failure rates and illiquidity?