A company’s size plays a major role in deciding the valuation method to use. For example, Facebook, when it needed to figure out the unique selling proposition (USP) of WhatsApp, considering its wide user base and growth potential, used the precedent valuation approach.
This is one of the three primary methods used in valuation, in addition to comparable company analysis and discounted cash flow (DCF) to value a company. The acquisition process also considered comparable transactions, such as Google’s acquisition of YouTube and Microsoft’s acquisition of Skype.
The company’s size (small, medium, or large) defines the valuation method, and choosing the best applicable approach is vital – Let’s see how it proceeds.
What are the Common Valuation Methods?
Before we discuss how the company’s size impacts the valuation method, let’s first understand the common valuation approaches used.
Market Approach
This approach compares a company with similar competitors in the industry. Companies can project their value by examining what businesses are worth. Finding the right comparables can be challenging, especially for small or mid-sized businesses.
Income Approach
The income approach is a progressive strategy that calculates the current value of future cash flows. Well-established large companies often utilize this approach, which is helpful for companies with consistent income sources.
Asset-Based Approach
Under this asset-based approach, the value of the company is calculated based on its tangible and intangible assets. In particular, the asset-based approach helps companies with heavy assets, like an industrial or real estate firm.
Whereas each approach has certain strengths and weaknesses, the size of the company may be a significant differentiator in choosing the valuation method.
The Impact of Business Size on Valuation Methods
For smaller companies, it is more difficult to obtain a valuation primarily because there are fewer financial information requirements and fewer market comparables.
Often, the asset-based approach applies. For example, a real estate business has a large part of its value in tangible assets- equipment, property, etc.- that would apply better with this approach.
The Income Approach is effective for larger firms, but it may prove challenging for smaller ones because cash flows may not be predictable. Startups or small-scale enterprises may never have a history of finances or stable earnings that can help make sustainable projections.
The market approach tends to be difficult since, more often than not, small businesses do not have direct competitors whose data is available in the public domain, and hence, they make less accurate comparisons.
An even wider scope of valuation methods exists for medium-sized enterprises. When companies have gained some traction and reasonably show that revenues and market presence are constantly rising, reliance on the market or income approach is relatively possible.
The market approach is most likely to yield adequate valuations for medium-sized firms. With reasonably stable cash flows, the income approach – the associated Discounted Cash Flow model-is better positioned to yield accurate valuations.
For example, a regional retail chain may use the income approach to project stable revenues, while the market approach might involve studying peer companies of similar size in the line.
Larger business enterprises are most flexible regarding the selection of valuation methods. They are more likely to depend on the income approach since they can formulate relatively predictable future earnings. Given historical financial data, larger firms can also accurately forecast cash flows, so the DCF method would be particularly applicable.
In addition, large companies typically belong to established industries, so they can use the market approach. This technique is preferred in manufacturing or finance fields, for example, where it is easy to obtain enough comparables.
How Industry and Sector Influence the Choice Based on Size
In addition, industry and sector play a role. Where the base is a technology-based sector, even small businesses may use the income approach because they project growth for their businesses.
Asset-intensive sectors such as construction or real estate tend to rely on the asset-based approach, regardless of size.
For medium and large tech companies, the income approach is preferred due to potential future earnings and high growth expectations.
The market approach may dominate in retail or manufacturing, especially for larger firms with readily available comparable public data. This shows that the dynamics of the sector also dictate which type of valuation method is appropriate for each.
Valuation Challenges for SMEs
The valuation of SMEs is more complex than that of large businesses because of the available financial information and comparable companies. The following are some challenges SMEs may face in the valuation process.
Financial and non-financial data of SMEs can be of less quality and quantity than those of bigger companies. Being private companies, SMEs do not have a wide spectrum of stakeholders and might not often create financial reports.
For instance, in some countries, financial statements may be influenced by the “tax value” rather than a fair assessment of the entity’s financial situation.
SMEs often have certain quirks. Many times, SMEs are family-run businesses. According to “The Role of SMPs Providing Business Support to SMEs,” these companies often want to keep family control and typically give great priority to non-financial goals (e.g., reputation, image, company, and life-work balance).
This requires the valuation experts to ask about the elements that can cause prejudices in the business valuation. This demands “normalizing” the entity.
The owner could be personally in charge of the SMEs. Will the company have the same opportunities without that owner? The valuer should gather suitable data to convey its view and incorporate their factors into future studies.
A Comprehensive Approach to Valuation
Your company’s size matters in the valuation process as it decides to utilize the right valuation method. Some companies opt for less complex, more straightforward approaches simply because they lack the resources or data.
In contrast, larger firms can afford to use more complicated and detailed approaches that reflect their broad scope of operations and the extent of their market participation. Navigating the valuation process at critical transitions, such as mergers, acquisitions, or fundraising, can be tricky.
Experienced professionals will guide the valuation process to give it appropriate characteristics specific to the business, which renders an accurate analysis of the given case. Generally, knowing the effect of businesses’ size on value is ideal in deciding such practices and taking up available value in a competitive market.
Ajay Rathod loves talking about artificial intelligence (AI). He thinks AI is super cool and wants everyone to understand it better. Ajay has been working with computers for a long time and knows a lot about AI. He wants to share his knowledge with you so you can learn too!