COMPANY VALUATION: What Boards Need to Know

In recent years, there has been a significant surge in the valuation of companies, a practice motivated by various factors. When contemplating the purchase or sale of a company, understanding its value is crucial before embarking on price negotiations. Likewise, for those interested in investing in a company, comprehending its value is paramount. Investment funds, venture capital firms, business angels, and, in general, anyone seeking to enter a company's equity will require knowledge of its valuation. Many organizations also opt for flexible remuneration structures, contingent upon the company's performance, and, in certain cases, particularly in startups, based on the company's projected value. In such scenarios, an increase in the company's valuation leads to higher salaries for employees, aligning their compensation with the company's growth in value. Family businesses often undergo valuation when distributing inheritances or donations, as it is integral to calculating the associated tax liabilities. If a company faces financial distress and enters bankruptcy proceedings, valuation is essential to ascertain the extent to which its assets can cover outstanding debts. In addition, companies may undergo valuation when divesting a production unit, acquiring a new company or product line to expand into new markets, or engage in vertical or horizontal integration. Furthermore, comparing a company's value with its quoted price is another use case for valuation.

In essence, company valuation is the process of determining the economic worth of a business or company. This valuation process is a critical element in financial decision-making, investment, and corporate operations. It is essential for purposes like mergers and acquisitions, divestitures, capital raising, financial reporting, and assessing the value of a company's assets. It is important to differentiate between value and price. The valuation of companies does not equate to their price. Value is subjective and depends on the evaluator, while price is an objective outcome of negotiation. As Warren Buffet famously stated, "Price is what you pay. Value is what you get."

Company valuation methods encompass a range of techniques for estimating a company's value based on its components and performance. These methods seek to quantify something inherently subjective - the value of a company. There are numerous valuation methods, each offering a different perspective and yielding varying results. To employ these methods, detailed company information, including audits, thorough analysis, a business plan, and a financial plan spanning at least three years, is typically required. A comprehensive valuation exercise often provides a range of values, with the highest valuation result at the top and the lowest at the bottom, with other results from different valuation methods falling in between. The choice of method hinges on the nature of the business, data availability, and the purpose of the valuation. In practice, a combination of methods is frequently used to triangulate and arrive at a reasonable estimate of a company's value. The valuation process may also entail adjustments for market conditions, risk, and growth prospects to enhance accuracy.

There are two primary categories of business valuation methods: static methods and dynamic methods. Static methods evaluate a company based on its past and current performance, relying on historical data and are relatively straightforward to implement. However, they do not consider the company's future evolution. Among static methods, accounting-based approaches typically report the net asset value, but adjustments may be necessary to reflect market values. Dynamic methods, on the other hand, assess a company's future potential and are widely accepted by economists. These methods are more complex as they require projecting future scenarios, demanding a deep understanding of the company, a robust business plan, and an economic and financial plan, ideally incorporating different future scenarios. Dynamic methods often involve discounting future cash flows to their present value. The discounted cash flow method, particularly the discounted free cash flow method, is a commonly employed dynamic valuation technique. This approach values a company based on the present value of its anticipated future cash flows, though the complexity lies in forecasting sales, costs, and investments over the coming years. To account for uncertainty, multiple scenarios may be considered, each subjected to the valuation methodology.

Another valuation method involves using multiples or comparatives, which entails comparing the target company with similar entities. This approach involves selecting a relevant company variable, such as net profit, EBITDA, or turnover, to be multiplied by a suitable multiple. To ensure the validity of the multiple, it's crucial to have a substantial and representative sample of comparable companies. Multiples per share price are often used when comparing publicly listed companies. In cases where there are no directly comparable public companies, multiples per transaction can be employed, relying on data from recent mergers or acquisitions. One of the frequently used multiples is EBITDA. Multiples valuation methods are relatively straightforward to apply, with the challenge lying in sourcing data from companies that closely resemble the one being evaluated. This method may not be suitable for companies that significantly differ from others in the market and does not consider the target company's future evolution, as it relies on current variables.

When it comes to company valuation, boards and decision-makers must have a solid understanding of various aspects to ensure an accurate and effective valuation process. They need to understand the specific purpose of the valuation. Valuations can vary based on whether it's for mergers and acquisitions, selling the company, raising capital, financial reporting, tax purposes, or any other objective. The purpose will dictate the methods and approaches used. As noted above boards must be familiar with the different valuation methods, including static and dynamic approaches, as well as the use of multiples. Each method has its strengths and limitations, and the choice should align with the nature of the business and the specific context. Boards must ensure that they access to comprehensive data about the company, including financial statements, historical performance, and relevant market data. A thorough audit and analysis of financial statements are often prerequisites. Recognize the risk factors associated with the business and industry. Risk can significantly impact the valuation, and boards should evaluate these risks and make appropriate adjustments. Consider the legal and tax implications of the valuation process, especially when it involves transactions, inheritance, or donations. Be aware of the tax regulations in the relevant jurisdiction. Ensure that the board includes members with expertise in finance, accounting, and valuation or consider consulting with external experts to guide the process. Comply with relevant financial reporting standards and regulations, which may vary by country, region, and industry. Boards must ensure that the valuation aligns with these standards. Valuation information may be sensitive and confidential. Ensure that appropriate measures are in place to protect this information, especially when discussing potential mergers or acquisitions. Boards should be able to effectively communicate the results and implications of the valuation to various stakeholders, including shareholders, potential investors, and regulatory authorities. In summary, company valuation is a complex and multifaceted process that involves various methods and considerations. Boards should be well-informed, have access to relevant data, and potentially seek expert advice to ensure a thorough and accurate valuation that serves the organization's specific goals.

Board Academy Br Cida Hess Farias Souza Eduardo Gomes, MBA, CCA IBGC Marcelo Simonato