VC/PE firms need to capture what a company will be worth to a potential acquirer. There are 3 fundamental methods to valuing a company:
- Asset approach – the company’s valuation is its net asset value (NAV) which is the fair-market value of its total assets minus its total liabilities. This method is generally used for businesses with substantial tangible assets as it does not factor in the future earning potential of the company.
- Market approach – the company’s valuation is determined from the appraisal value of its assets, based on the price of comparable items on the market, with adjustments made for differences in size, quantity or quality. This approach can be used to value a business as a whole, its assets or securities.
- Income approach – the company’s valuation is determined based on the sum of future cash flows and economic benefits that the company may generate in its lifetime. One method of this is the net present value (NPV) of expected future cash flows. The sum of the company’s future cash flows is discounted by a capitalization rate to determine the present value of future cash flows, giving the present-day value of the company.