How is company valuation calculated?

Question

There are many TV shows where people present their ideas and investors are ready to invest if they like the Idea.

So, I was watching one of those TV shows when I saw that a person came with a unique bicycle invention and presented it to investors. He clearly mentioned that currently he has nothing, not any sale nor any customer. He just made this bicycle which seems to be a great invention and investors in that show really liked it and were ready to invest. So, he asked for around 40K dollars for 10% equity.

The thing that confused me was that the TV show showed a tag on screen where it was showing a company valuation of around 400K dollars.

How was that 400K dollars company valuation calculated if he had not sold any unit, did not have any customer? He just had this idea on hand. He even did not have any factory or any assets. He was just a boy with a unique idea; that's it.

Because, as far as I know, any company's valuation is depended on its sale, customers and assets, etc. Or am I wrong? Or is that based on some assumptions?

Answer 1

There are many ways to calculate valuation. Some are random numbers, some are based on business plans and market research, some are based on investors' perceptions of companies' finances and reports, and some are based on supply and demand.

In this case, we don't know how the person came up with their valuation, but they offered 10% of the company for $40K - it means that they value 100% at $400K.

Answer 2

It's simply an estimate by the company founder. He predicts that if he can get this company going, investors will soon value it at at least $400K. Based on that assumption, he's offering the "shark" a 10% share of the company at $40K.

In order to form this estimate, he may have consulted with financial analysts and experts in the industry. He's created a business plan that describes how he expects to operate the company, and they've then estimated how successful this is likely to be.

Answer 3

There are many different ways to valuate a company but at the end of the day the “value” of a company is determinate by the “value” that the buying and the selling side agree on. In your example the entrepreneur sets a value of the company at $400k and its selling 10% of the company for $40k. If the buyer agrees, this will set the value of the business “officially” at $400k.

This is in essence how all businesses are valued whether privately sold business, start-ups or public companies on the stock market. The value of a business is determinate by the price that both sides (the buyer and the seller) agree upon. In different situations and different types of business the both sides are considering a multiple factors like:

• does the company have any revenue
• is the company profitable or not
• how big is the potential demand for the product
• is it in a competitive industry or not
• is the product unique and innovative
• is it a growing or dying industry
• how big are the profit margins
• is the product offered solving a real problem that no one else is doing etc.

Different methods and techniques are used in different situations depending on what information the both sides are focused on. For example:

In the VC world the buyers and sellers are more focused on metrics like: how fast the company is growing, how big the potential addressable market is, what sort of disruptive technology is using etc.

In the stock market a lot go these factors translate to metrics and ratios like:

• PE ratio - which tells you how much you are paying for the current earnings (profit) of the company. For Apple with current PE of 26 you are paying $26 for every $1 of earnings that they are making.
• PS ratio - same as PE but for revenue. Usually used for companies that are not profitable yet. For Tesla with current PS of 15, you are paying $15 for every $1 in revenue.
• PEG - which is similar to PE ratio but calculates for the annual growth of the business etc.