In today’s world of startups, we find many ways to give a startup its initial valuation. With the many ways to value a company, many entrepreneurs find themselves unsure of what to do and results in them undervaluing all of their hard work and dedication.
The net present value (NPV) approach to valuation is the first of three valuation methods I will speak to here. NPV is defined as the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
The equation for NPV is as follows:
Ct = net cash inflow during the period
Co= initial investment
r = discount rate, and
t = number of time periods
Because of the time value of money, valuing a company using cash flows is hard. The time value of money can be as a dollar today in not worth a dollar tomorrow, accounting for inflation. A common way to evaluate the discount rate is to look at returns on investments of a similar risk level.
For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount of, say $600,000. If the owner of the store was willing to sell his business for less than $600,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $600,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.