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Company Valuation and Investors – What are the Different Types of Valuations and Approaches in Company Valuation?

Valuation of a company is more of an art than a science.  No formula is fixed for business valuation of a company.  Valuation becomes very important in the eyes of the investors.  It is a basis on which an investor assumes that the venture will be capable of returning or not returning the amount invested on it.

There exists a lot of confusion around the concept of valuation of a company and its actual value.  Generally, value of a company is its market cap (or) market capitalization and it is represented by the company’s stock price.  Valuation, on the other hand, is the price a company receives to effect a sale of the entire business.  For instance, the value of Flipkart is US$142.24 per share in the end of December 2015, while its business valuation is estimated at US$9.39 billion

Types of Valuation

 

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Pre-money valuation is the value ascribed by the company before the investment made by the investors.  If an investment is done to your existing Pre-money Valuation, then Equity to the Investor = 100* (Investment Amount)/(Post-money Valuation)

Post-money valuation is the sum of total of investment and pre-money valuation of the company.  If investor says that he will invest a certain amount of money at a certain Post-money valuation, then Equity to the Investor = 100* (Investment Amount)/ (Investor specified Post-money valuation).  Pre-money evaluation methods are profitable to the ventures while the post-money evaluation favors the investors.  The following examples support the claim;

Let us take an example that a company X needs an investment of US$5 million and it has a pre-money valuation at US$20 million.  As per the formula, the equity to its investors will be equal to (5/(5+20)) * 100 = 20%

Now let us assume that the post-money valuation is followed, and the post-money valuation of the company is US$20 million.  With all the other assumptions remaining same, we can calculate the equity to the investors as follows: (5/20) * 100 = 25%

From the example, it is evident what kind of impact these methods have on equity that an investor gets from the venture.  Note that if an angel investor or an incubator/accelerator commits to invest, say US$5 million at a valuation of US$20 million, it means that the investor points to post-money valuation, not the former.

Cash Flow

Another important part is the cash flow statement of the company.

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Estimation of Total Market of a Product

Top-Down Approach:  For a market which is scalable. Eg. Facebook, WhatsApp, etc.

  • Determine the potential for the product or service in the market.
  • Determine the share of the market that can be targeted by the venture.
  • Estimate the operating expenses or margins for the estimated revenues.
  • Estimate the re-investments needed to generate the estimated growth.
  • Multiply the expected pre-tax operating income by the tax rate.

Bottom-Up Approach: For a market which is NOT scalable. Eg. Flipkart, Cloud Computing, etc.

  • Determine the capacity size or investment to be made to get the business running.
  • Determine the number of units that should be sold for the forecasted period and at what price.
  • Determine the operating costs.
  • Determine the taxable incomes in the estimate.

Techniques for Valuation of Companies.

The below mentioned methods are popular for determining the business valuation of a company;

  • Score card method
  • Dave Berkus Method
  • Risk Factor Summation
  • Venture Capital Method (VC)

Do’s and Don’ts

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