Valuing a business is one of the most important elements of any private market transaction. It determines the price a buyer can pay, sets the ground for deal terms negotiations, and can even help some buyers and sellers decide whether they want to proceed with a potential deal.
In this article, Finro shares their 5-step process to build an initial business valuation using the comparables method.
TABLE OF CONTENTS
What is a business valuation?
A business valuation is estimating how much a business is worth.
Every business owner and executive knows that the business valuation reflects the shareholders’ benefit from the company’s future financial performance. The problem is that benefit is a subjective term—one person’s gain might not be another person’s gain.
The benefit from investing or buying a business is subjective, so the valuation of that investment is also subjective.
People often believe that a business valuation is simple math—you put numbers into a black box, and it shoots out a value for a business.
However, there are three potential problems with this: What numbers do you enter in the black box, how does the black box process the numbers, and how do you handle the output number?
The comparables valuation method solves the first two problems above and makes the calculation easier, which makes it useful for valuing any business.
In some cases, the comparables valuation is used for a quick and dirty initial valuation before adding more methods, it could be used as a preliminary step before deciding whether to proceed with the deal or as the main valuation method if not much information is available.
Building the comparables valuation
A comparables valuation is a relative valuation method that uses the value and financial performance of similar companies to calculate a business’ worth.
The comparables valuation involves three parts: the comps analysis, the previous transaction, and the financial forecast.
The Comps Analysis
The comps analysis is the heart of the comparables valuation.
We’ll start by making a list of the companies we think we should research. The companies could be direct competitors, market leaders, or companies with similar business models active in the same niche. We’ll look online for information on these companies.
The basic information we’ll look for is:
- Latest valuation, Enterprise Valuation (EV), and market cap for public companies.
- Trailing twelve months (TTM) revenues, EBITDA, EPS, or another financial factor we want to use.
With these data points, we’ll be able to build the EV to revenues, EV to EBITDA, price to sales, and price to earnings multiples.
The total multiple for the entire comps list is the arithmetic mean or weighted average of all the individual company’s multiples in the list.
For pre-revenue companies, we’ll focus on the enterprise value to revenues multiple. For a mature, EBITDA-positive private company, we’ll use the enterprise value to revenues multiple as well as the enterprise value to EBITDA multiples. For a publicly traded company, we’ll use the price-to-revenues and price-to-earnings multiples.
We typically recommend using as many data points as possible to build a number of multiples and create a more balanced comparables valuation that is not based on a single multiple.
The previous transactions are another part of the comps analysis, but it uses a different set of data.
Here, we add real market data from previous transactions in the niche. We use the target company’s valuation or deal price and the target company’s TTM revenues and EBITDA to build the EV/Revs and EV/EBITDA of actual deals, then add them to the comps analysis.
There are a few data points that we need to add to our analysis depending on the type of company we’re valuing and what we’re trying to achieve.
The first set of numbers is the trailing twelve months or latest annual revenues or EBITDA. When we apply the multiples, we could get a preliminary estimate of the current company’s worth.
The second set of numbers is the weighted average of the projected annual revenues and EBITDA. We do that by assigning weights to each year’s projected revenues and EBITDA (or earnings), starting from the biggest weight in the first year and the smallest weight in the fifth year. The weighted average of these numbers will create an annualized revenue or EBITDA forecast.
By applying the annualized figures from the comps analysis to the multiples, we get the full potential value of this company.
Since valuation is subjective, as we mentioned at the beginning, at this stage, the party who builds the valuation we apply the most reasonable projections it believes are accurate for the company. In most cases, this is the point where buyers and sellers don’t see eye to eye.
Benefits of the comparables valuation
- Easy to understand and explain.
- Applicable to any business.
- Improves and focuses the discussion.
The great benefits of the comparables method are also what causes people to underestimate it: it’s simple, accessible, and extremely useful.
The biggest advantage of the comparables method is that it’s so straightforward. When you get to a point in the deal when you have to explain the target company’s valuation, the comparables method works like a charm.
The comparables method includes only two components at the end—multiples and annualized revenues/profits/EBITDA— so it’s super easy to explain even to a non-financial savvy person, unlike explaining the discounted cash flow (DCF) or the weighted average cost of capital (WACC), which could be extremely challenging sometimes.
The structure of the method allows users to calculate a variety of multiples related to earnings, revenue, and EBITDA—thus making it a flexible option for both an early-stage pre-revenue startup and an SMB with a positive bottom line.
When the discussion turns to comparables and future earnings or revenues, the focus is on the important aspects of the valuation and not on technical calculations as often happens with other methods.