By Collins Kuindwa
When it comes to fundraising, mergers and acquisitions, the most common question asked is, “What is the business worth?” A seemingly simple question, however, in order to get the answer one must carry out a valuation.
So what does a valuation entail?
Carrying out a valuation is not complex; we (the people who practice valuation) just choose to make it complicated. I’ll tell you why.
In layman terms, valuation of a company is a short process involving the followings steps:
Step 1: Determine the value of existing investments or assets that are currently generating cash flows in the business today. Typically the value of such assets will be the summation of all future expected cash flows from these assets.
Step 2: Determine the expected value of future investments. This can be referred to as growth assets.
Step 3: Sum up the value of existing assets (determined in step 1) and growth assets (determined in step 2).
Step 4: Determine what is owed to third parties by the business; the value of borrowed moneys.
Step 5: Deduct the amount of total borrowings (determined in step 5) from the total asset value (determined in step 3)
But does this mean anyone can do valuation?
Not necessarily. Here’s why?
In mature companies (and by mature companies I mean those that have passed the test of time) – most of the value is derived from existing investments that have already been made. However, in young growth companies, commonly referred to as startups, existing assets are minimal and can barely form a good justification for value. It gets more challenging when you come across a young company that is not making any money (commonly referred to as idea companies)- where then do we get the value?
We get the valuation from expectations, perceptions and future hopes as guided by the founders of these young growth companies.
The way you come up with a valuation will be very different based on the type of company you are looking at. If it is a mature company, you need to be very focused on the earnings reports. If it’s a startup, focus should be in the expected value that will be created by future investments! Because, ideally speaking, the valuation of a young growth company does not come from what happened last year; it is coming from the value that will be created in the future. This makes valuation a little bit messier. This is because this is a value attached to investments expected to be made one year into the future, two years into the future, three years into the future… so on and so forth. This involves forecasting the expected stream of cash flows from the growth assets, their expected level of risks. This gives room for ‘manipulation’.
‘Manipulation’ you ask?
I could tell you more but the purpose of this blog post is not to make you a valuation guru but rather to help you identify when you should be in doubt of a business valuation.
No matter how sophisticated or simple the valuation methodology is (which is what we have tried to highlight above) or how experienced and knowledgeable the valuers are, or how glamourous the presentation is, the first thing you need to do after receiving a valuation number is to carry out a reality check!
What do you mean, ‘reality check’?
The valuation has to be practical.
The valuation has to be realistic.
The valuation has to be in sync with what is happening on the ground and not just an abstract number supported with abstract assumptions. And that is why you’ll hear the rather common phrase, ‘Excel money is real money!’
What are you buying when you are buying the company? Or, if you are on the sales side, what are you selling when you sell this company?
A great way to carry out a reality check is to ask a set of very specific questions. Assuming that the valuation you are staring at, (yes, that unreasonably big number you have in front of your screen, highlighted in bold and prepared by a team of highly intelligent consultants) is a correct representation of the value of the company and you were to spend that same exact amount (yes, that unreasonably big number) in purchasing property or land in a prime real estate location, would the value you receive from the prime property or land be the same? If the answer is yes, then by all means, that unreasonably big number is a good representation of the value of the company. If no, then ideally the company has either been overvalued (good news for a seller, but terrible for a buyer) or undervalued (not so good news for a seller but great news for a buyer).
We therefore advise that before you are comfortable with a valuation that you have either come up with or one that has been presented to you, do a reality check! If it adds up, all is good to go. If not, you might have to go back to the drawing books!
Happy valuation folks! And remember, there is no such thing as a correct valuation.