Valuation is the cornerstone of most private market transactions.
When a buyer wants to buy a small business, an investor wants to purchase equity in a startup, or a founder wants to cash out on some shares, valuation is crucial.
The valuation can indicate whether a business justifies the asking price.
It can help founders calculate how much of their business they need to sell to raise a certain amount.
It can also help a business understand how much it’s worth in the market.
In most cases, to complete a private market transaction, you’ll need a business valuation.
One problem is that many think valuation is a complex process, with many complex calculations needed to estimate how much a business is worth.
But, there is no need to be intimidated by the concept of valuation. In many cases, this does not have to be a complicated process, especially in the tech sector.
By using the comparables valuation method.
What is the comparables valuation method?
The comparables valuation is a relative valuation method that uses similar companies’ value and financial performance to calculate a business’s worth.
Every founder or business owner will tell you that the value of a company is determined by how much money it makes.
Many valuation methods take that simple concept and complicate it to the extreme based on various financial theories. But the great thing about the comparables method is its simplicity.
This valuation method has only two components: the multiple and the financial figures to apply. No complicated financial concepts. No super complex financial theory. No fancy calculations. Just a straightforward calculation.
One of the tremendous advantages of the comparables method is that it applies to any company. And I mean every company.
Pre-revenues startup? No problem, just use the revenues multiple.
Late-stage startup or mature business? We got you covered. You can use the revenues multiple AND the EBITDA multiple.
Publicly traded company? The price-to-sales and price-to-earnings are just for you.
The comparables valuation method is so useful because you can apply it to any company without losing the simplicity of the calculations.
First, what is a multiple?
It is basically the ratio between the company’s worth as reflected by the enterprise value market or capitalization to its annual revenues, EBITDA, earnings, or any other financial figure we choose.
The three most common multiples are revenues, EBITDA, and earnings.
Second, how do I find out the comps multiples?
You’d need to build what we call a comps analysis. It’s basically a table that summarizes the revenues, EBITDA, earnings, enterprise value, and market cap (and other figures if you want) of every comparable company we chose to use in our analysis.
In that table, we’ll calculate the different ratios.
We’ll get to the revenues multiple by dividing the enterprise value (EV) by the annual revenues, the EBITDA multiple by dividing the EV by the yearly EBITDA, etc. For publicly traded companies, we’ll divide the market cap by the annual revenues or earnings.
This is how the comps analysis should look like:
How to build the multiples?
The multiples used in the calculation are the weighted average of the multiples of the company’s comps. We’ll use multiples according to the company’s stage:
- Enterprise value (EV) to revenue multiple for pre-revenue companies.
- EV to Revenue and EV to EBITDA for mature, EBITDA-positive private companies.
- Price-to-sales and price-to-earnings for publicly traded companies.
The more multiples used in the calculation is better. It creates a more balanced comparables valuation that is not based on a single multiple and does not lean toward a specific financial figure.
We’ll add multiples of previous deals in the niche to the list of comps’ multiples. This will diversify our list and make it less dependent on a single company and less affected by the performance of one extremely bad or successful company.
The Financials Figure To Apply
We need to couple a different financial figure to each multiple above to calculate the company’s worth using the comparables method.
First, we’ll need the last twelve months’ revenues (the latest annual revenues can also work. We’ll estimate the business’ worth based on actual figures by multiplying the trailing twelve months’ revenues with the multiple revenues. This is the current valuation.
We’ll repeat the same process with EBITDA instead of revenues when using the EV to EBITDA multiple.
Second, to calculate the potential value of the business, we’ll look at its financial forecast. More specifically, at its forecasted revenues and EBITDA. We’ll assign a weight to each forecast year to build a weighted annual average revenue or EBITDA. Typically, the first year will have the highest weight, and the last year will have the smallest.
By multiplying the annual weighted average revenues or EBITDA with the respective multiple, we’ll help us estimate the future potential value of the company.
You can combine these two values to get a total valuation or use them separately, depending on your needs. For pre revenues business, the current valuation part is not relevant.
So what’s so great about the comparables valuation?
The comparables method is a simple way of valuing a company. If you’re in a position where you need to explain the target company’s valuation, the comparables method is an effective tool.
It only includes two components at the end—multiples and annualized revenues/profits/EBITDA—making it very easy to explain even to anyone, regardless of their financial knowledge level. This is not always the case for other valuation methods.
The method is structured to allow users to calculate a variety of multiples related to earnings, revenue, and EBITDA—making it flexible for both an early-stage pre-revenue startup and a small-to-medium business with a positive bottom line.
When presenting a company’s valuation using the comparables method, the discussion naturally revolves around the core components of the analysis: future earnings and revenues, rather than technical calculations as with other methods.