- In this three-part series of articles, we will look at the different ways one can value a company.
- In finance, a company is worth the net present value of all its future cash flows.
- Valuation calculations can be made through comparable companies or precedent transactions.
“If I work really hard, can I become a billionaire like Adam Neumann?”
Don’t take this the wrong way, but the answer is “probably not”, as the circumstances that propelled WeWork to its peak $47 billion valuation in 2019 are very unlikely to be repeated any time soon. So, if not $47 billion, how much is your business worth?
This is the first of a series of three articles that will try and answer that question, looking at company valuation in general and the valuation of coworking and serviced office firms in particular.
So, what is the value of a company?
The classic answer in market economics is that it is worth what someone else will pay you for it, in an arms’ length transaction. Although that doesn’t get you very much further in knowing what the value is, it does help explain the WeWork phenomenon as we will see in the final article of the series.
At their peak, WeWork’s shares were worth $47 billion because that is what Softbank was prepared to pay for them. (This theory of valuation is also known colloquially as the ‘greater fool’ theory, as you only have to find someone who is a greater fool than you to sell to.)
Another classic answer, this time from finance, is that something is worth the net present value of all its future cash flows. That answer is more helpful and, as we shall see, forms the basis of one of the four principal methods of valuing businesses.
Those methods can be thought of as:
1. The comparable companies method;
2. The precedent transactions method;
3. The discounted cash-flow method; and
4. The asset based valuation method.
The first two of these methods are market based, that is to say that the value calculated using them is dependent on the state of the market at the time and thus, subject to change as markets rise or fall.
The second two are more fundamental and less subject to the whims and fancies of short-term investors in the market, because they do not depend on today’s market price.
Let’s look at how these methods are used.
The principle of the comparable companies method is a very simple one.
If you want to know the value of something you own, one good way to do it is to find something similar whose value you do know and compare it to yours. So, if I wanted to value the 1959 Cadillac deVille I once borrowed for a few months when I was a summer intern in Connecticut, I would look on the classic auto sites for another one, and then compare mine with that one, based on condition, mileage etc. If I couldn’t find a 1959 model, I would check the price against a 1958 model or a 1960 model, as they would be roughly comparable. (Actually I am not sure than anything is really comparable to a 1959 ‘fishtail’ Caddy, so maybe that’s a poor analogy.)
The same process applies to businesses.
If I want to value a 10 location coworking firm, I look for a similarly sized firm whose value is known, either because it is quoted on a stock exchange or because it was recently valued, and use that as a comparison.
When comparing Cadillacs, we were looking at condition and mileage, but with companies we would be comparing various important financial and operating ratios which would tell us how good the respective businesses actually are. These ratios might include standard financial ratios such as debt to equity, or interest coverage, but also industry specific ratios like Revenues Per Available Workstation or REVPAW, a measure invented by Regus ahead of its IPO and much derided at the time for its speciousness, until WeWork came along with its ‘community adjusted EBITDA’ which took first prize for the most meaningless number of 2019.
Investment analysts who do this sort of valuation work professionally have financial models which do a lot of the number crunching and speed up the comparison. To a certain extent, the process can be considered a scientific one in the sense that it is based on data analysis, but, in fact, the end result is based largely on professional judgment, as will be clear when we come to consider how to reconcile the inconsistent valuations produced by the different valuation methodologies.
For example, it is a matter of professional expertise and judgment knowing which ratio is important in which circumstances, and how to interpret the numbers produced by the model.
The second method uses precedent transactions rather than looking for comparable companies, but is otherwise very similar to the first method. This second method is mainly used when it is not possible to find a comparable company, or to find enough of them to obtain a meaningful result.
You might not be able to find a comparable company if your business is unique, or if there are no quoted companies similar to yours or in your location. There are not many quoted coworking businesses in the world and most countries have none at all, so it is difficult or impossible to find a comparable company whose market value is known. This is a particular problem for owners in smaller countries where it may not be reasonable to compare a local coworking company with IWG or Servcorp.
To use this second method, you look for a transaction rather than a company to use as a comparison. The transaction is likely to be the sale of a business, or an outside investment into a business, of the sort that Softbank did to WeWork. To give an example from my other professional field, the law, there are very few quoted law firms in the world, and none in the USA, as it is not allowed. Despite this, there is a ready market for buying and selling law firms. So if you have a law firm for sale and you want to know what it’s worth, you would look for previous sale transactions to give you an idea. In a similar fashion, when an investor is looking to acquire a business in an ‘exotic’ country where the market values on the stock exchange may not be a reliable guide to value, an indication may be obtained by looking at previous sale or investment transactions, even if in different fields of operation.
When using the precedent transaction method, it is fairly obviously better to use the sale of a similar business as a comparison if at all possible, rather than a completely different one, so there is a distinct overlap between the comparable companies method and the precedent transactions method. The difference between the methods is largely one of focus – are you concentrating on the company or on the transaction?
One final point to note is that the precedent transactions method systematically overvalues the target business because, by definition, the value includes the control premium. That is to say, because the method looks at deals that have been done, the buyer has paid the premium to acquire the target. The comparable companies method does not include the control premium so the values obtained would tend to be lower.
Stay tuned for the second article in this series.
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