# Valuation: What is and how to calculate the value of a company?

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Valuation is an English term for Business Valuation. It is a set of financial methods to determine the fair value of a business, whether for its acquisition, for the entry of a new partner or to determine the expected return of its shares in terms of dividends.

## What is Valuation?

An entrepreneur starts a business. At first he can handle all the assignments, but the venture is growing and he feels the need to put another person on the team. Due to high cash requirement of the business, instead of hiring someone, he decides to bring a new partner to the boat.

A relationship with potential begins. But when it comes to defining investment and shareholding, both of them ask themselves:

How much is the company worth ???

Many Brazilians have already gone through this situation, either in the entrepreneur's shoes or in the investor's shoes. In most cases, an opinion-based negotiation is waged until, after both yield, a middle ground is found. The question is: could anything better have been done?

Yes. The answer is Valuation. In other words, valuation is the science that serves to attribute fair market value to companies. Although it is a study that can become quite complex in its mathematical foundations, its premise is quite simple:

The market value of a company will be proportional to the future income that it is able to generate

In other words, how much will it generate for profit, or cash flow positive, in all its existence? It seems complex and philosophical, but there are different techniques for performing a valuation job. We'll talk about them below.

## Why is Valuation important?

Valuation is a set of techniques used in various aspects of economics and business management. A good example is the financial market, which uses it to assess whether asset prices are consistent before investing or not. If a stock, for example, is cheaper than the company valuation it is interesting to buy it.

Another common use is in the IPO (Initial Public Offering) of large companies. This is the time when they open up capital and need to set the stock price to make an initial offer in the market. If the price is totally mismatched from valuation, there is high risk of the IPO being a failure.

I cited examples that may be far from your reality, but the truth is that valuation is also increasingly used by small entrepreneurial journey. The goal is to make agreements between administrators, partners and investors fairer and facilitate negotiations.

Recently, the program Shark Tank Brasil it started to become popular here and it was clear that Brazilian entrepreneurs need to go deeper in this area. Many wanted to receive surreal investment amounts for a very small percentage of their actions. When a company proposes this type of agreement, it is quite feasible that it will throw its funding possibilities down the drain.

In several Brazilian entrepreneurship centers, we are observing the emergence and growth of several startups. They are companies, generally technological, created to obtain fast growth, maintaining lean structure.

Entrepreneurs of this medium need to go deeper into valuation. Startups undergo several phases of fundraising before they become profitable and mistakes in valuing companies are often fatal.

## Different Types of Valuation

Now that you have understood the importance of valuation for business, it is time to go to the practical side. I'll start by listing different methods for doing valuation.

### Discounted Cash Flow - DFC (Discounted Cash Flow)

The DFC method, discounted cash flow, is the most widely used type of valuation in the world. Later in this article, we'll show a example of valuation calculation using the DFC. It consists of the projection of future cash flows of a company and the application of a discount rate to bring them to present value.

The logic for such is one of the principles of financial mathematics:

Money today is worth more than money tomorrow.

In other words, if I offer you R \$ 1.000 with the following conditions of choice:

1. Redeem R \$ 1.000 today.
2. Redeem the same R \$ 1.000 from 10 years ago.

I'm sure you would choose the first option. The same logic applies to the DFC model. The positive cash flows generated by the company lose financial value over time. Therefore, there is a need to calculate a rate that discards cash flows more and more, as time progresses.

Over time, the values ​​of the cash flows will tend to zero, due to loss of value. In addition, cash flow projections will be increasingly ineffective. Think about what is more difficult, for example, to imagine how much your company will generate next year, or in 50 years from now. Therefore, in the DFC, it is common to design 5 to 10 years of cash flow, to then apply a formula of perpetuity.

Perpetuity is an asset that has financial returns forever.

In short, the DFC valuation formula would look something like this:

DCF = [FC/ (1 + r)1] + [FC/ (1 + r)2] + ... + [FC/ (1 + r)n]
where FC is the result of the cash flow in each period and r is the discount rate.

### Market Multiple

The market multi-valuation method consists of finding indicators of companies in the same industry and relating them to their market value. Usually billing is used, EBITDA or profit, with the proviso that companies in different stages have different returns. For businesses on the Internet, specific indicators such as active users or subscribers can also be used.

For example, let's say I own a company that produces beverages and has net revenue of \$ 2 million per year. Knowing that AMBEV's market value in the Brazilian stock market is around R \$ 350 billion and its net revenue is around R \$ 50 billion, its multiple market value for net revenue revolves around 7. Applied to my beverage company, 7 x 2 = R \$ 14 million market value.

The multiples method has a number of defects. The most crucial is not to consider intangible assets such as the brand. He also does not consider the timing of the company analyzed. Also, it is very difficult to find companies that are 100% of the same industry.

In any case, the multiples method is widely used to support the DFC method. Valuation is carried out via discounted cash flows. After finding the market value, the entrepreneur (or a consultant, or someone interested in investing), presents multiples of the market to show that the number is correct.

### Sale off

The settlement method is not much used as it is not at all attractive to the seller. As the name says, it is most often used when the company is closing its activities.

The settlement method takes into account just how much the company would get in its tangible assets - properties, vehicles, equipment, machinery, etc. - in a short amount of time. In other words, if a company is closing the doors, how much does it get for the "scrap" left over in 2 months.

This explanation alone, already shows that this method is used in the last instance, in the situation of desperation of the seller.

### Accounting

The accounting method is similar to the settlement method, however it does not consider the time variable. Instead of considering how much the firm would achieve by assets in a short time, it considers the Balance Sheet of the company, discounted from its depreciation or amortization.

It is a very unattractive method for lean companies such as startups because they seek to grow only in intangible assets and user base.

## How to calculate the value of a company?

To exemplify the valuation concept, we will now show you step by step how to calculate the market value of a company using the DFC method, that is, discounted cash flow.

### Step 1 - Designing Cash Flow

The first step is to project the company's cash flows to the next 5, 10 or 20 years. The logic to choose the deadline is to try to think about the horizon of stability of the company. Larger companies, or in sectors with fewer changes (construction, oil and gas, etc.), have future cash flows with a higher level of reliability.

Smaller companies, in more dynamic sectors, or even business ideas, have low reliability in their projections. In this way, it is worthwhile to project in detail a few years and apply growth rates in the cash flow accounts for the following years.

The projection process is very similar to the Economic Feasibility Study. It is strongly recommended to use a Valuation Worksheet for the preparation of this work.

First are projected revenues, applying annual growth rates from previous years.

For companies that do not have previous cash flows, the work is a little more complex, as it will involve a more in-depth study of possible medium ticket scenarios and sales volume of different product and service lines.

After projecting revenues, the projections should be different expenses (fixed and variable). Typically, in a valuation project, they are not considered interest, tax, depreciation and amortization expenses.

At the end of the process, you'll get something like this:

It is absolutely normal to have a projection that varies in terms of growth rate at its inception. For a nascent company, the projection will usually look like this: negative start, high growth in the middle and stabilized end. For more consolidated companies, the projection will be more stable throughout the period.

### Step 2 - Defining the Discount Rate

The discount rate is the most difficult part of valuation and one of the themes that generates most discussions in the universe of financial mathematics. Its logic is not complex. It is a rate that devalues ​​financial flows over time due to their uncertainty. And it illustrates the opportunity cost of the operation, that is, the "loss" that the investor will have to rely on these cash flows instead of betting on safer yields.

Thus, by definition, the discount rate should be above the basic rate of the economy, the SELIC rate, in the case of Brazil. It is quite common to use as discount rate the average corporate income on the Bovespa or an average fixed income income, which indicates other investment possibilities, other than the company in question.

But as I said, there are more complex and deeper studies for the discount rate that consider the company's cost of capital, profitability and average risk inherent in the industry that the company occupies compared to the economy as a whole, among other factors.

In our example, I will use a discount rate of 10%, which considers our SELIC added to a small risk premium. But, if you want to go deeper into the subject, I recommend that you read books about valuation.

### Step 3 - Discounting Future Cash Flows

As we said before, the formula for discounting cash flows, that is, bringing them to present value, will be:

DCF = [FC/ (1 + r)1] + [FC/ (1 + r)2] + ... + [FC10 / (1 + r)10], where r is the discount rate.

Making the calculation for the calculation flows found in Step 1, we will have:

### Step 4 - Calculating Perpetuity and Bringing Present Value

The company will not end in the year 11 of the projection. Nor will he stop giving profits. However, its growth in the projection already shows greater constancy and, therefore, we can calculate the profit of the year 11 next with a formula of perpetuity.

This formula will be no more than the amount of the annual cash flow divided by the discount rate. If we believe that the flow will continue to grow 5% per year, the formula will look like this:

Perpetuity = FC11/ (rc), where r is the discount rate and c is the annual growth.

Assuming that FC11 will be cash flow for year 10 plus a 5% growth: R \$ 409.809,14. Thus, the calculation will be:

Perpetuity = 409.809,14 / (0,1-0,05) = R \$ 8.196.182,73.

Okay. Great! But remember that perpetuity is still in the 11 year, in our timeline. We need to bring it still to present value, as we did with the other cash flows:

PerpetuityVP = [8.196.182,73 / (1 + 0,1)11] = R \$ 2.872.712,04.

### 5 Step - Consolidating

To conclude, we only need to add the cash flows in present value with perpetuity, also in present value:

Valuation = R \$ 1.757.256,09 + R \$ 2.872.712,04 = R \$ 4.629.968,13.

This means that if a company is looking for a partner to buy 20% of their company, it can raise up to R \$ 925 thousand.

## Crucial Tips for Evaluating a Company Correctly

We finish the financial part of valuation, but incredibly, despite all this work, it is not the most important. Before doing the business with our eyes closed, we need to analyze whether the figures presented make sense from the abstract point of view. In other words, does the company have the resources needed to achieve the estimated cash flow returns?

To evaluate them, we separate some tips below.

### Take a fundamentalist analysis

Fundamental analysis is an analysis that seeks to answer whether factors essential to the company's success are favorable. These factors may be intrinsic to the company or external, relative to competitors and the economy as a whole. We will not delve into the subject, but some questions may help with the topic:

• Is the company already growing?
• Is it profitable or does it at least show signs that it will be profitable one day?
• Is the market in which it is embedded expanding?
• Are there strong competitors? Do they innovate within this market?
• Are there predictions of new technologies that will help the company grow more or become more profitable?
• The most favorable legislation prediction?
• Is the company team qualified and balanced?

The first three types of valuation indicated in this article show examples of corporate valuations based on fundamentalist appraisals.

### Evaluate scenarios

If you do not believe the numbers will materialize, make different projections and estimate probabilities for them. O First Chicago Method, for example, works with 3 projections:

• The worst case scenario, in which the company went quite wrong
• The realistic scenario
• The best possible scenario, if all the factors of fundamentalist analysis are favorable

In our example above, let's say we believe that there is 20% chance of giving everything wrong and our valuation stays in R \$ 1.000.000. But let's also say that we believe that there is a possibility of 5% to be all right and valuation go to R \$ 20.000.000. The final calculation will be:

Valuation = 0,2 x 1.000.000 + 0,75 x 4.629.968,13 + 0,05 x 20.000.000.

Valuation = 200.000 + 3.472.476,09 + 1.000.000 = R \$ 4.672.476,09.

I hope you enjoyed the article! If you have any questions, leave your comment below. And do not forget to see our Excel Valuation Worksheet!