It's an important question for any entrepreneur, business owner, employee, or potential investor -- for any size company. And like most complex mathematical problems, it depends on a variety of factors.
If you're an entrepreneur, understanding the value of your company becomes increasingly important as the business grows, especially if you want to raise capital, sell a portion of the business, or borrow money.
For investors, company valuation is a critical component in determining the potential return on investment and if the company is "fairly valued" at the time of the investment.
And for employees, company valuation is especially important if you're granted stock or stock options. A higher valuation might mean the options will increase in value.
Various company attributes must be considered to properly value the company. This includes vertical market and industry performance, proprietary technology or commodity, company operating experience, stage of growth, revenue & profitability growth, management team, and execution to plan.
There are also outside factors including comparable company performance, overall economic factors, market sentiment, and growth rate. When you add in the impact of technology (every company is influenced by technology) it becomes quite complex to come to a definitive equation.
A simple valuation can boil down to a few factors. Next, we'll take a look at how these different elements are used to value a business.
How to Value a Business
Market Traction and Growth Rate
Sustainable Competitive Advantage
Future Growth Potential
1. Company size
Company size is commonly used as one factor to determine the value of a company. And typically, the larger the business, the higher the valuation will be. This is because smaller companies have little market power and can be more negatively impacted by the loss of key leaders. Plus, larger businesses likely have a well-developed product or service and easier access to capital as a result.
Is the company earning a profit? If so, this is a good sign for the valuation. Businesses with higher profit margins will be valued higher than those with low margins or profit loss.
3. Market Traction and Growth Rate
The market traction and growth rate of the company are compared to competitors. Investors want to know how large your market is and how quickly you can capture a share of the market. The quicker you reach the market, the higher your business' valuation will be.
4. Sustainable Competitive Advantage
What sets your product, service, or solution apart from competitors? The way you provide value to customers needs to differentiate you from the competition. If this competitive advantage is too difficult to maintain over time, this could negatively impact the business' valuation. A sustainable competitive advantage helps your business build and maintain an edge over competitors or copycats in the future.
5. Future Growth Potential
If investors know your business is going to grow in the future, the company valuation will be higher. Is your market or industry expected to grow? Or is there an opportunity to expand the business' product line in the future? Factors like these will boost the valuation of your business.
The financial industry is built on trying to accurately define the current growth potential and the future valuation of a company. All the characteristics listed above have to be considered. The key to understanding future value is to determine which factors weigh more heavily than others.
Just like any asset, a company's valuation is what someone is willing to pay for it. And there are different metrics to value public and private companies.
Public Company Valuation
For public companies, the company valuation is typically referred to as the market capitalization -- where the value of the company equals the total number of outstanding shares multiplied by the price of the shares.
For example, let's say Apple's price per share is $166 and the number of outstanding shares is 4.75 billion. In this case, if you multiply the price per share by the number of outstanding shares, Apple is worth $788 billion.
Public companies can also trade on book value -- the total amount of assets minus liabilities on the company balance sheet. The value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset.
Private Company Valuation
Private companies are often harder to value because there's less information, a limited track record of performance, and financial results are either unavailable or might not be audited for accuracy. Let's take a look at valuations of companies in three stages of entrepreneurial growth.
1. Ideation Stage
Startups in the ideation stage are companies that have an idea, a business plan, a concept of how to gain customers but they're in the early stages of implementing a process. Without any financial results, the valuation is based on either the track record of the founders or the level of innovation that potential investors see in the idea.
A startup without a financial track record is valued at an amount that can be negotiated. Most startups I've reviewed start with a valuation between $1.5 and $6 million if it's started by a first-time entrepreneur.
All the value is based on the expectation of future growth. It's not always in the entrepreneurs best interest to maximize the value of the company at this stage if the goal is to have multiple funding rounds. Valuation of early-stage companies can be challenging due to these factors.
2. Proof of Concept
Next is the proof of concept stage. This is when a company has a handful of employees and actual operating results. At this stage, the rate of sustainable growth becomes the most important factor in valuation. Execution of the business process is proven and comparisons are easier based on available financial information.
Companies that reach this stage are either valued based on their revenue growth rate or the rest of the industry. At this stage, the company is valued based on its peers and how well it's executing versus its plan. Depending on the company and the industry, the company will trade as a multiple of revenue or EBITDA (earnings before interest, taxed, depreciation and amortization).
3. Proof of Business Model
The third stage of startup valuation is the proof of business model stage. This is when a company has proven its concept and begins scaling to prove it has a sustainable business model.
At this point, the company has several years of actual financial results, one or more products shipping, statistics on how well the products are selling, and product retention numbers. All the factors listed above can be analyzed to determine a more accurate company valuation.
Business Valuation Calculators
How do you determine the value of your business? Below are business valuation calculators you can use to estimate its value.
This calculator looks at your business' current earnings and expected future earnings to determine a valuation. Other business elements the calculator considers are the levels of risk involved (e.g., business, financial, and industry risk) and how marketable the company is.
ExitAdviser's calculator uses the discounted cash flow (DCF) method to determine a business' value. To determine the valuation, "it takes the expected future cash flows and ‘discounts' them back to the present day".
No matter how it's calculated, company valuation is important to a business' growth. If you're looking to borrow money or sell a portion of your business, you'll need to know how much your company is worth. To learn more about entrepreneurship, check out these small business ideas next.
Originally published Feb 1, 2019 8:30:00 AM, updated February 01 2019