How do I value my business?

Ever wonder how communities started? Obviously no caveman went the Darwin way without a ’hood. It was only when hunters and gatherers turned into herdsmen and agriculturalists that early forms of commerce began to develop. Flints and other hard stones suitable for weapons or tools were exchanged for other commodities. This barter system was the foundation of modern-day commerce. The absence of a unified currency, though, meant there was no universal standard of prescribing value.

The invention of coins (or currency, or money) revolutionized the basis of valuing anything that could be bought or sold. It created a universal standard of how we ascribe value to material (and sometimes immaterial) objects. A thousand years later, it’s all about player money. Hence the saying “cash is king.” 

For money to have so much power, its value is set at a certain level. After all, not everyone can be on top. Yet, too much money wasted (yes, I’m talking to every high-living rapper and NBA player out there) becomes froth on the monetary cappuccino. 

The combination of a common currency and markets (or exchanges) led to the creation of an efficient pricing mechanism. Simply put, markets or exchanges help establish the value or price of a product that serves as a reference point for all other buyers or sellers. If gold, for example, is valued at $1,200 per ounce on the commodities market, all other buyers and sellers can naturally refer to this price as a basis of doing a transaction.

The reality of such markets brings about a mathematical notion of an efficient pricing mechanism. By pooling many buyers and sellers together, the eventual price set by the marketplace is seen to be efficient or representative of the value of that product or good at that time. If you buy barrels of oil and gold in the commodities market, you can actually see the established value of any product in money terms. The statistical probability of a perfected price is much higher with many buyers and sellers on both sides. While the irrational highs and lows of the market have demonstrated that markets, like people, can behave emotionally, more often than not the markets are the best mechanism we have for establishing an efficient price for commodities, equities, bonds, fixed-income instruments, or any object that is bought or sold on a regular basis. 

It is important for entrepreneurs to understand how to properly value a business. This comes in handy when looking to buy or sell a company. While there are volumes of books dedicated to the topic of valuation, I will attempt to summarize the most practical and commonly accepted methods of valuing a business. 

1. Discounted Cash Flow (DCF) 

This is essentially the present value of all future cash flow that the business is expected to produce over the life of its existence. 

The future cash flows are then discounted into its “present value” based on a discount rate, which is considered the cost of capital and risk factor associated with that business. 

The net present value of all future cash flows is then considered the full valuation of the business. A similar concept is used for lottery ticket winners in the USA. Jackpots are in the $100-million range but are actually paid out over a 15-year period (say, slightly more than $6 million per year). Banks or financing companies will offer winners a lump sum of, say, $45 million, which is their way of saying that $100 million over 15 years is only worth $45 million today. 

The same concept is true for valuing a business. It basically values what the future potential of that business is worth today. 

I’ve only been involved in one deal where the investors actually used the full DCF value of the enterprise as the basis of valuing how much they were willing to pay for my company. In general most investors will refer to the DCF to understand the full value of the company, but they will almost never agree to pay that price (as by definition it fully values or fully prices the business). 

2. Market Comparables (Comps) 

This is by far (based on my experience) the most widely practiced and commonly accepted valuation method. 

It is anchored on the theory of efficient market pricing. Market comps look at the valuation of other similar businesses in the same sector, and derive the multiple used to determine its valuation. 

Price to sales, price to EBITDA (earnings before interest, taxes, depreciation and amortization), price to earnings (p/e), and price to book are what are commonly used. 

P/E multiple is the more popular reference. Stock market analysts, retail investors and laymen use this to look at the pricing of a stock in relation to other companies. 

Usually a basket of similar companies are selected, and an average p/e is derived. For example, all companies on the Philippine Stock Exchange (PSE) as of today have an average p/e of approximately 20x. The average p/e of technology companies is about 35-40x. This means relative to earnings, tech companies are priced higher than average companies. A comparatively higher multiple can be justified if the company has promising growth prospects. 

Thus another ratio called p/e to growth ratio is used (or “peg”). This allows investors to go beyond p/e and look at peg, which then factors in company growth rates in relation to its p/e multiple to really determine if a company is priced affordably, relative to its growth rate. It is usually okay to pay a high p/e multiple for a company if its peg ratio was acceptable (i.e., the company’s high valuation is supported by a high growth rate). 

Back to market comps, if all tech companies are trading at, say, 35x p/e, then this is the basis of selecting the p/e for a tech company that is about to list or is not publicly listed. 

If the company is private and smaller than those used in the basket, then discounting the average p/e multiple to take into account the premium larger listed companies command is normally done. So if the average p/e is 35x, after discounting for various reasons, the applicable multiple that can be used to value your smaller private tech based business would end up in, say, 22-23x. 

If your business is not profitable, a price to sales or price to book is more applicable. 

Market comps is not perfect. It doesn’t take into account the strategic value your firm can give a potential acquirer or vice versa. Nor does it take into account future growth if your business is at a very early stage and not that comparable to market comps being used. It does, however, form a basis, though, which is a great starting point. In many of the deals I’ve done, market comps was the most influential method in determining the price at which we would do a deal. Call me old-fashioned, but I generally prefer this method. 

3. Return on Investment

This is a very crude and rudimentary approach, but you can look at the total amount of money that you and all your investors have put into the business, and add a premium to that number. The “premium” can be a percent or multiple. Although every seller wants a higher price, just like every buyer wants a lower price, to be realistic you cannot use this method in a vacuum. Use it in conjunction with market comps so that you can determine whether you and your fellow shareholders will be satisfied with a given price based on how much of a return you will generate. Ultimately, this is what proves to be the determining factor of a deal: whether buyer and seller are happy or satisfied with the pricing on a deal. 

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With all that said, I hope Philippine diplomacy can mend our strained ties with our Chinese superpower neighbor. Doing so will lessen the “Philippine discount” or discount investors apply to a Philippine-based business given all the systemic issues we have in this country. We should know that our worth is also dependent on our sense of community with our neighbors. I think a top-selling book aptly called it Rich Neighbor, Poor Neighbor. If you are poor, you must maintain a productive relationship with your more affluent brothers and sisters.  

It is important for us to maintain and build economic, political and cultural ties with China and Hong Kong. Successfully doing so will achieve a higher valuation for Philippine-based businesses.  We must build a sustainable relationship with foreign economic powers that can benefit the local economy. This is key to the future of our economic development and growth. 

No money, no honey.

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Any questions? E-mail me at egtheplayer@gmail.com.