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How to Value a Business

One of the more interesting realizations I had in my "PE days" is that valuation is as much about art as it is science, which is to say there are technical steps we can take, but there's also an intangible element of "feel."

In an attempt to keep it simple, what we're trying to do here is similar to buying a house: we're looking at the house itself, when it was built, the structure, the yard, the fixtures, all within the context of its neighborhood and town.

With that said, let's explore some of the "standard" valuation methodologies that are used when you're considering investing in or acquired a company in an M&A context.

🗺️Where are we Again?

A few weeks ago, I shared the "Due Diligence Roadmap." Right now, we're somewhere between reading the CIM and building the model. See the image below:

EBITDA Multiples

Technical Steps:

1. Identify Comparable Companies: Look for companies in the same industry and market size.
2. Get the Multiples: Find or calculate the EBITDA multiples these companies are trading at.
3. Calculate Target EBITDA: Take your company's EBITDA from its financials.
4. Apply Multiple: Multiply your target's EBITDA by the average or median multiple from your comp set.

Good For: Quick and dirty valuations in M&A or PE scenarios, but will be refined over time.

Additional Context: EBITDA multiples are at the top of the list because they were used 99% of the time throughout my PE career, and are the basis for a "cash free, debt free" valuation. The next two valuation methods below (CCA and Precedent Transactions) will usually help support the EBITDA Multiples analysis, which is why I've put them all at the top.

Comparable Company Analysis (CCA)

Technical Steps:

1. Identify Comps: Find companies in similar industries, stages, and sizes.
2. Select Metrics: Choose key metrics (P/E ratios, P/S ratios, etc.).
3. Apply to Target: Use these multiples as a basis for valuing your own company.

Good For: Situations where multiple comparable companies are available.

Additional Context: In my experience, CCA is most commonly used to help support the EBITDA Multiples analysis, but you may calculate a handful of other metrics to provide additional context for the valuation. For example, "our EBITDA Multiple valuation is [$X] and our Price-to-Sales Ratio is [$Y], which is comparable to several other companies in similar industries."

Precedent Transactions

Technical Steps:

1. Find Past Sales: Identify transactions where similar companies were sold.
2. Extract Multiples: Note down the multiples at which they were sold.
3. Apply to Target: Use these multiples to estimate the value of your company.

Good For: Contextualizing valuation within recent market activity.

Additional Context: Recalling the sentence from the intro, all of this comparison work is to help us value the company within its "neighborhood," which is to say businesses and industries that are similar. The more industry context we have, the better we can support our valuation. Imagine if you found a house sitting all alone in a giant field with nothing around it. How would you value it? You can start by guessing, but you'd need more context to get comfortable with your number.

Price-to-Sales Ratios or Revenue Multiple

Technical Steps:

1. Calculate Valuation: Shares Outstanding x Current Share Price or propose a "cash free, debt free" valuation.
2. Get Revenue: From the income statement.
3. Divide: Valuation by Revenue.

Good For: Young or high-growth companies without consistent profits.

Additional Context: What do you do when a company doesn't have any EBITDA? Just because it doesn't generate positive profit doesn't make it worthless. Think about Uber, Lyft, or Snapchat: all wildly negative in terms of profitability. However, are they worthless? Absolutely not.

This is when "price-to-sales" or "Revenue Multiples" enter the picture. Just like you can find EBITDA Multiples for similar companies, you can do the same for Revenue. This is where "feel" starts to enter the picture, and despite some of the ridiculous valuations we've all heard about in Financial news, most often I found Revenue Multiples to be in the 1.0x - 3.0x range depending on the upside and "sizzle" of the company.

Discounted Cash Flow (DCF)

Technical Steps:

1. Forecast Free Cash Flows: Usually for the next 5-10 years.
2. Calculate WACC: Weighted Average Cost of Capital.
3. Discount Cash Flows: Use WACC to bring future cash flows to present value.
4. Sum Them Up: Add all the discounted cash flows together.

Good For: Scenarios where financial projections are relatively reliable.

Additional Context: This may frustrate some of you, but I rarely (if ever) used DCF valuations on the job. Yes, they're taught in academic circles and you'll hear refrains like CAPM, WACC, and Terminal Value, but I almost never encountered them in practice.

Why? Well, for starters they're notoriously unreliable. Let's be honest: no one has any idea what the financial condition of the company will look like in five years. None. So to claim you have a "reliable" forecast is just a bit silly. Follow that with how much the discount rate affects the analysis, and suddenly you're all over the place (even if you give me a fancy sensitivity table).

Before you know it, you're back to looking at precedent transactions and building EBITDA multiples like we've discussed above. It's much more common to see DCF valuations used in Project Finance to assess the NPV of a possible capital project, but not as common for company valuations (at least in my experience).

Price-to-Earnings (P/E) Ratios

Technical Steps:

1. Calculate EPS: Earnings Per Share = Net Earnings / Shares Outstanding.
2. Compute P/E Ratio: Share Price / EPS.

Good For: Stable, publicly-traded companies with a track record of earnings.

Additional Context: Readily available and common to use for public companies, but not as common in the private sector.

Let's Take a Quick Break

The methods we discussed above are the most common. Below, I've listed several more just to round out the topic, but they aren't as commonly used. Again, 99% of the time I used EBITDA Multiples, with the occasional Revenue Multiple for companies that weren't profitable.

Let's close out...

Sum of the Parts (SOTP)

Technical Steps:

1. Identify Components: Break down the company into different business units.
2. Value Individually: Apply the most appropriate valuation method for each.
3. Sum Up: Add them all together.

Good For: Valuing conglomerates or companies with multiple lines of business.

Net Asset Value (NAV)

Technical Steps:

1. List Assets: Everything from real estate to IP.
2. List Liabilities: All debts and obligations.
3. Subtract: Assets - Liabilities.

Good For: Asset-heavy companies, like real estate portfolios.

Cost-to-Duplicate

Technical Steps:

1. Inventory Assets: Both tangible and intangible.
2. Estimate Costs: Include costs of all assets and human capital.

Good For: Startups, tech companies, or companies with unique IP.

Liquidation Value

Technical Steps:

1. Inventory Assets: Everything that can be sold.
2. Estimate Sale Price: What you’d get in a quick sale.
3. Subtract Liabilities: Pay off debts.

Good For: The unfortunate scenario where a company needs to be shut down.

Additional Context: I've seen this play out, and for many it can be a tough pill to swallow. Terms like "fair market value" and "upside" disappear, and a lot of equity value can get wiped out. What we're talking about here is selling physical assets in the short term and what, if any, proceeds they can generate. From here, you start to pay back "the waterfall," meaning any debts get paid off first, and then (if there's anything left), you would pay off the equity, usually at a "haircut" for everyone. This is not a fun process to go through, but it happens.

In Summary

As you can see, there a bunch of different ways to value a business, which often boils down to a delicate balance of science and art. In my experience, EBITDA and Revenue Multiples were the most common, but your career trajectory may be different.

Big picture, we're trying to answer a relatively simple question: "what is this company worth given the context in which it operates (other companies in the same industry)."

You're just feeling things out or "kicking the tires" as people love to say, but it's the first step of many for what's to come.

That's it for today. See you next time. —Chris

See it in action.

I usually teach the EBITDA Multiples method because it's the most common.

So if you're interested, please consider enrolling in ​my Financial Modeling courses​ to see how we build EBITDA and ultimately calculate a cash free, debt free valuation.

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