BDC Consulting’s most important mission is to help clients optimize the value of their business. The question then is: how is the value of a company properly assessed? In this article we will talk about the key valuation methods and the main mistakes startup founders make when using them.
An accurate valuation of a company helps founders and investors make sound financial decisions: for example, whether to sell a stake in a project, abandon it entirely, or acquire a company. Regulators also need it to assess risks; and financial forensic experts, to calculate the value of the guarantee.
Cryptocurrency startups primarily use business valuation when dealing with potential backers. In addition to a quality blockchain product, a company needs a financial model that works in different market scenarios and can serve as a basis for decision-making.
In addition to traditional capital fundraising, the crypto industry provides a unique opportunity to invest in tokens, the legal status of which is not yet clearly defined in many countries. This article focuses on the previous aspect: valuing stock investments. We will leave the topic of investing in tokens for a later review.
There are three main methods of asset valuation: income-based, comparative, and cost-based. The name of each method reflects how the evaluation works. In addition, several secondary titration methods have been derived from these three to refine the results.
The Discounted Cash Flow (DCF) Analysis Method
The DCF valuation method is based on the future cash flows of the company, bringing them to the present time through discounting. This is the most popular business valuation methodology because it considers the money the business will earn in the future, even if the project is not currently making a profit. We will not discuss how to calculate discount rates so as not to overcomplicate the matter.
A valuer using DCF considers that a company exists forever and therefore always produces cash flows. At the same time, the evaluation period is divided into prognostic and terminal, increasing the risks as one moves away from the current moment.
Throughout the forecast period, the company can foresee its future and can plan a business with a high degree of confidence in the market and its product. For a classic business, the forecast period is between 8 and 15 years.
In contrast, the terminal period is the period beyond the forecast, which can extend to infinity. To assess terminal cash flow, an appraiser uses the discounted sum of cash flows for all years beyond 8 to 15 years. The firm’s terminal growth rate is also important, that is, the rate at which cash flows will increase annually.
For example, let’s take a business that generates a steady cash flow of $100 per year for the next 7 years. So, with a discount rate of 10% and a terminal growth rate of 3%, the value of the business in the forecast period will be $487.
The discounted terminal value is $733:
The overall cash flow is $1,220, which can be considered a fair valuation of the business in question.
The DCF approach, being a subtype of the income method, represents the value of a company as the sum of the two cash flows, forecast (i.e., the amount of money the company plans to earn in the coming years) and terminal. (the residual value of the company).
The relative valuation method
This method ranks a company against others in the industry based on comparable criteria, such as the number of active users, connected wallets, unique visitors, etc. Similar companies can be selected by analyzing financing deals that have already been made or public companies in the industry.
When working with these criteria, appraisers use multipliers, such as EV/Subscribers, where EV stands for Enterprise Value (the fair value of the business) and Subscribers represents the number of paying product users.
Suppose we need to calculate the value of a streaming service. Knowing the cost of an analog company, the number of subscribers to our service and the audience of the analog service, we can determine the value of our company.
If our competitor’s service has 300 subscribers and its value is estimated at $900, then the value of our business with 500 subscribers will be $1,500.
This method is often used as a control method to confirm the results obtained under the DCF approach. Over a broad sample of similar startups and using various methods, the correct estimate should fit the range of valuations obtained through each of the methodologies.
The Cost Approach
The cost valuation method reflects the amount of money spent on creating a business. The most common approach is called the net asset method. Consider the value of a business as the difference between the value of the assets and liabilities of the business. Since this method is not widely used in the evaluation of emerging and developing companies, we will leave its analysis outside the scope of this article.
Comparing the three methods
It is much easier to give a correct assessment using different approaches at the same time. More and more often, when analyzing the value of crypto companies, a combined method of visual estimates called “football field” is used. For example, it can be found in unbiased pitch decks and opinion reports.
The chart above compares the valuation ranges obtained by DCF Valuation, comparative methods (Precedent Valuation, Comparable Valuation) and the company’s share value over the last 52 weeks (52-Week Trading Range). Given the project’s current valuation of just under 4 units, an investor may decide to buy a stake, as the business has the potential to increase in value.
One way or another, crypto business owners are faced with the need to assess their business, but they often do it poorly. In our experience, founders often make mistakes with their financial contributions and future growth rates.
To create a DCF business valuation model, it is essential to correctly interpret the input data: market size, user base growth, revenue growth rate, etc. , negatively represent the forecast values.
To avoid such errors, we recommend entering multiple scenarios into DCF financial models, each with their own future values.
There are also often misconceptions about the terminal growth rates of companies. If you overestimate or underestimate this indicator, the error can reach tens of percentage points. We recommend basing the model on the company’s conservative growth rates, even for new blockchain companies, unless the company has good reason to assume otherwise.
DCF is the most popular method of estimating the value of a crypto business. DCF-based financial models take into account both potential opportunities and risks. The main danger in using DCF is incorrectly evaluating the terminal growth rate or the input data.
The relative titration method provides useful values for comparing DCF results. The main difficulties, in this case, are the search for relevant information, the comparability of the startups evaluated and the selection of relevant companies for comparison.
Understanding the business valuation process helps crypto businesses reasonably deal to buy or sell shares and raise capital investments at different stages.