How do investors value a business?

What process do investors use to value businesses?

I’ve heard of several different formulas used. Is it fair to say that there is no single model of valuation?

It is certainly fair to say there is no single model of valuation. Here are two types of valuation that are commonly used to value a company:

Methodology 1: Financial metrics

This method considers financial metrics, usually revenue and/or EBITDA, to see if the business is profitable. In this model, take the metric and multiply it by a benchmark multiple to arrive at the valuation.

Benchmark multiples are obtained by seeing what multiple similar, successful businesses are trading at.

For example, carsales.com.au is trading at about 8x revenue and 15x EBITDA. If your company was comparable to carsales.com.au, but had $2.5 million in revenue and $500,000 in EBITDA, then you could establish a value range of $7.5 million (using EBITDA) to $20 million (using revenue), which nicely illustrates how different metrics give different results.

But note that, in this example, carsales.com.au has fantastic profitability with around a 50% margin. Your business does not, with profitability of around 20% ($500,000 / $2.5 million). As such, it is important to pick the right comparables.

More commonly you might use multiples from the average of a sector, which for Australian online companies is more like 12x EBITDA and 4x revenue. This then narrows the valuation range to $6-10 million for your company.

The rationale for using multiples is that they reflect the price that an investor will be paid on exit, so they represent a fair way to value the business going in.

But, as we have seen, there is a fair bit of variability depending on which metric (e.g. revenue vs EBITDA) you pick and which comparables. For early stage companies, usually revenue is a better metric, as they may not have a positive EBITDA, and even if they do, it may be skewed by fixed costs, which take up a relatively large proportion of expenses as the company grows.

Methodology 2: Qualitative

As an alternative to financial metrics, you could also look at a more qualitative approach. Using this methodology, you value a business today based on the financial objectives for the investment.

For example, if a business is potentially worth $60 million, and it needs $3 million of investment to achieve this outcome, then in order for the investor to make five times their money, they’d need to get $15 million of the sale price, and therefore own 25% of the equity.

So if the $3 million investment is going to equate to 25% equity, the pre-money valuation of the business is $9 million.

There are two standout numbers in this example. Firstly there is the “five times” return. While you may be thinking “Cor, blimey!” the issue is that five times is the unrisked target return.

Unfortunately, many investments are going to fail, that is just the nature of the business. Therefore in order to still make a decent return, successful investments need to return an outsized amount.

The actual target returns multiple depends on the assessed risk of the business and usually ranges from about 3x up to about 10x.

The other standout number is how do we value the business at, say, $50 million? Doesn’t that just get us right back to the original question? In this case, using multiples is much more reliable.

Given the exit is three to five years out, the business will have critical mass and be much more comparable to its peers – either a select few, or the sector.

To determine that value, we take the projected financials in the business plan and determine an exit value subject to success (which is already accounted for in the return multiple).

So to arrive at a final valuation for your business, you could consider the valuations from both methodologies and perhaps arrive at something somewhere between the two.

After that, it comes down to negotiations between you and your prospective investor.