New Venture Valuation (Asset Based, Earnings Based, Discounted Cash flow Models)

Several startup valuation methods are available for use by financial analysts. Startups, in the most general sense, are new business ventures started up by an entrepreneur. They usually tend to focus on developing unique ideas or technologies and introducing them into the market in the form of a new product or service.

Business valuation is never straightforward for any company. For startups with little or no revenue or profits and less-than-certain futures, the job of assigning a valuation is particularly tricky. For mature, publicly listed businesses with steady revenues and earnings, normally it’s a matter of valuing them as a multiple of their earnings before interest, taxes, depreciation, and amortization (EBITDA) or based on other industry-specific multiples. But it’s a lot harder to value a new venture that’s not publicly listed and may be years away from sales.

Asset Based

This approach focuses on the fair market value (FMV), or the net asset value (NAV) of the company. calculated the total assets less the total liabilities to figure out the cost of re-creating the company. There is little room left to decide which of the assets or liabilities of the company has to be included in the company valuation and how exactly we measure the worth of each.

Other than this, there are two other methods of valuation that are used. The market approach, which looks at what similar businesses in the market are worth, and the earnings approach, which estimates the total amount of money that they business might produce in the future.

The actual value in the asset-based approach to calculate the company valuation could be much higher than the sum of all the recorded assets of the business. Let us take for instance the balance sheet of the company. The balance sheet may not always have all the significant assets like the company’s methods of conducting business and internally developed products.

This happens as only the records which the owner has paid for appear on the company’s balance sheet. So, if there are other assets of the business, they are not recorded in the balance sheet. Other than this, some companies may have special products or services that make them unique. Putting a price on these for selling the business can be difficult.

Adjusted Net Asset Method

The adjusted net asset method can be used when a company has been generating losses, is not operating or the company only holds investments or real estate. This is one of the methods of valuation that is utilized for getting the estimated value of the business.

To get the fair market value, we would have to get the difference between the fair market value of the total assets and the total liabilities of the company. Let us understand how it is done.

Finding the Fair Market Value of Assets

The asset-based method of valuation starts by preparing a financial image of the business from the information that we have on the balance sheet. The current asset value would be different compared to the acquisition costs. Even though the balance sheet has all the assets and liabilities listed on it at historical cost, correctly utilizing this approach is based entirely on recasting those costs and obtaining the current value.

Earnings Based

This is another common method of valuation and is based on the idea that the actual value of a business lies in the ability to produce revenue in the future. There are a lot of methods of valuation under the earning value approach, but the most common one is capitalizing past earnings.

Capitalization of earnings is determined by calculating the NPV (Net present value) of the expected future cash flows or profits. The estimate here is found by taking the future earnings of the company and dividing them by a cap rate (capitalization rate).

In short, this is an income-valuation approach that lets us know the value of a company by analyzing the annual rate of return, the current cash flow and the expected value of the business.

This approach of the capitalization of earnings, being one of the conventional methods of valuation, helps investors figure out the possible risks and return of acquiring a company.

As soon as all the variables are known, the calculation of the capitalization rate is obtained with a simple formula. The formula is operating income divided by the purchase price. At first, the thing to be determined is the annual gross income of the investment.

After this, the operating expenses has to be subtracted to find out the total operating income. Then this value is divided by the investment’s/property’s purchase cost to find out the capitalization rate.

Disadvantages of Capitalization of Earnings Method

There isn’t one perfect method to determine a company’s value, which is why assessing a company’s future earnings has some drawbacks. At first, the method used to predict the future earnings might give an inaccurate figure, which would eventually result in less than expected generated profits.

In addition to this, exceptional circumstances can occur that eventually compromises the earnings, and affect the valuation of the investment. Further, a business that has just entered the market might lack adequate information for finding out an accurate valuation of the company.

The buyer has to know all about the desired ROI and the acceptable risks, as the capitalization rate has to be reflected in the risk tolerance, market characteristics of the buyer, and the expected growth factor of the business. For instance, if a buyer is not aware of the targeted rate, he might pass on a more suitable investment or overpay for an investment.

Discounted Cash flow Models

For most startups especially those that have yet to start generating earnings the bulk of the value rests on future potential. Discounted cash flow analysis then represents an important valuation approach. DCF involves forecasting how much cash flow the company will produce in the future and then, using an expected rate of investment return, calculating how much that cash flow is worth. A higher discount rate is typically applied to startups, as there is a high risk that the company will inevitably fail to generate sustainable cash flows.

The trouble with DCF is the quality of the DCF depends on the analyst’s ability to forecast future market conditions and make good assumptions about long-term growth rates. In many cases, projecting sales and earnings beyond a few years becomes a guessing game. Moreover, the value that DCF models generate is highly sensitive to the expected rate of return used for discounting cash flows. So, DCF needs to be used with much care.