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How to Measure Your Business's Profitability

Added on - 01 Dec 2020

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19thand 23rdOctober 2020Business Model Innovation – Lecture 2 and 3How do you assess the profitability of the business model?There are two sorts of methods:1.Net present value method2.VARIM analysisNet present value analysis:-All businesses will generate income in the future-One way to value a business model is to calculate the stream of income it willgenerate and discount it by the appropriate rate.-Often the discount rate may be the return investors want to earn-Otherwise, the discount rate is the present rate of interestOne way to value a business model is to say what is the stream of income it will generateand discount it by an appropriate rate of return.It is meant by the appropriate rate of return for the entrepreneur - this could be the rate ofinterest charged for capital funds that they may have to borrow to run the business.For a shareholder or somebody interested in taking a share of the business, it might be whatis the return that they expect.The discount rate is the cost of borrowing the capital, or it is the rate of return that aninvestor may want to earn.NVP formula:
One very useful application of the net present value is in understanding whether stocks areover or undervalued.Using NPV to value businesses:-Distinguish between start-up, scale up and exit stages of businesses-Data available in each stage is different-A company available I. each stage is different-A company scaling up is easier to evaluate as there is some history of revenues infirm and industry-Usually compare P/E ratio or PEG ratio with that of an analogue.-Valuation quite important at the time of IPODrawback of valuation with NPV:-High data requirements-Use of analogues – ignores differences between firms (and their capabilities)-A static notion of value – as it also ignores the role of competition and externalenvironment-VARIM offers a more dynamic analysis.The more data you feed this formula, the better the estimate of the present value. The useof analogues can help overcome this lack of data. Still, it ignores the differences betweenthe firm's capabilities and also, of course, the net present value analysis doesn't put anyemphasis on the competition, so it's a very static notion of value, it does not recognise therole of competition or the external environment.Valuation of start-up:-No history of revenues so NPV is difficult to use-Investors and consumers are arbiters of value-Investors offers often reveal their valuation through their offer-If investors pay £y for x% of the business-We can infer that investor’s valuation of the business opportunity is £100(y/x)-This can be different from the founder’s evaluation
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