The Art of Valuation II

Continuing “The Art of Valuation” series, we give a brief review of the valuation methods that the entrepreneurs can use to value their companies before engaging any investors.

With the experience of company valuations, investors (usually former investment bankers) can make a good estimate of how much a company is worth and the amount of equity they seek from the startup company with their investment. They enter into a negotiation process with a clear idea what they want. For the entrepreneur, you need to do the same. Most entrepreneurs, regardless of their age groups, don’t seem to have a good idea on how much their business is worth, and how much investment they need from the investors and worst, most of the time, they gave away too much for too little. Here are some common ideas to give you a brief idea on how to do the estimates for valuation of your company:

• 1. Price/earnings ratio: The price/earnings (p/e) ratio is a common method of valuation used for established companies with a reasonable track record. The method adopts a multiple to the after-tax profits of the company. The simplest rule of thumb is that the multiple will increase as the company’s growth expectations increase. One uses a multiple between 8 and 12 for a mature company, and a multiple of 20 or even 30 for high growth companies (particularly high tech companies).
• 2. Sales Multiples: One can estimate the value of a business by the aid of comparable values using known and existing businesses as a benchmark. Examples of good metrics are the price/earnings ratio (PER) and the market to sales ratio.
• 3 . Return ratios: All investors view profit maximization as their primary self-interests. To do so, they look to maximize the return on investments (IRR). The IRR is the compound rate of return of the cash flows associated with a particular investment. It is the method used by venture capitalists to determine the relative attractiveness of an investment opportunity.

[1] New Venture, “Starting Up: Achieving success with professional business plan”, McKinsey & Company.
[2] Koller, Goldheart and Wessels, “Valuation”, 4th Edition, McKinsey & Company.
[3] Bygrave, Hay and Peters, “The Venture Capital handbook”, Prentice Hall.

Read more from our series Guide to starting an online business.