Figuring out a business’s value: voodoo or science?

Valuations for companies with low profits are often hard to understand at first, but they’re usually linked to the growth potential of the target, their intellectual property and the macroeconomic environment.

Figuring Out a Business’s Value: Voodoo or Science?

What goes into a business valuation? Obviously, profits play a role, as Pomanda’s Business Valuation Calculator demonstrates…

But anyone looking at the sky-high valuations of buzzy startups will tell you that profit alone can’t account for such large numbers. In these cases, it can seem that valuations are more voodoo than science, with numbers appearing to be assigned at random in the hope that the company turns out to be a ‘unicorn’.  However, many companies demonstrate values comprised of aspects aside from profit. As well as crunching numbers, here are a few factors contributing to the worth of a company that you might not have considered – no dark arts involved.

Potential for Growth

Generally speaking, a company’s growth potential will determine the valuation methodology. For example, if a company is relatively young but has high revenue growth, the valuation may focus on future earnings, whereas a mature company with steady growth is more likely to be valued on current earnings.

If a company’s valuation seems high for its current size, it could be that the business has a large growth potential. Perhaps its business model is easily scalable, or it has a unique, memorable brand or it is situated in a consistently thriving market. A business that has lasting power and an impressive capacity for development is likely to receive a higher valuation than a trendy business with major flaws in the way it operates.

Scale

In an established marketplace, revenue can be difficult to grow organically. Aggressive marketing and sales can make an impact; however, in a mature market, you are less likely to see a large spike in revenue than you would be in a new disruptive sector.  One strategy corporates take is to execute a ‘buy and build model’, growing revenue through acquisitions and taking advantage of cost savings through shared resources.  If a company has significant market size it is likely to fetch a higher multiple than a smaller company with similar margin metrics.

Quality Employees

The people who make up a company can greatly influence its value – and a business’s high-profile leaders are not its only valuable employees. People in mid- and lower-level positions are also crucial, particularly if they’ve been with the company for a long period of time, since they demonstrate the company’s retention rates and provide evidence of stability. If a business is looking to sell, these employees become even more important, as potential buyers will look to them to maintain operations during the handover and to provide a source of corporate history. In addition, many tech companies have taken to making ‘acqui-hires’, where they acquire a company for the talent rather than the technology.

The State of the Market

It can be easy to overlook just how much impact the state of the market has on a business’s valuation. When a market is new, people often want to be a part of it. They buy shares and products and place their confidence in the businesses that are driving the excitement, which contributes to higher valuations for the companies within the market. But it’s important to remember how quickly the state of the market can change. When you’re thinking about how the market could affect a business, you might look at past trends, barriers to entry and its overall stability.

 Customer base

Research shows that it is 6-7 times more expensive to secure a new customer than it is to maintain a current one. It’s no wonder, then, that having a strong customer base is a major factor in determining value. During a business sale, potential buyers may also pay special attention to customer mix and longevity. A company with only a few key customers might indicate a greater chance of failure than a company with a well-diversified client base, as the loss of one customer could cause a big problem.

The next time you’re baffled by a business valuation, remember that the value of factors like the ability to scale, a large customer base and quality employees are subjective. They will have varying impacts on multiples on a case-by-case basis – so keep them in mind when you’re looking at revenue and bottom lines.

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