The problems described above lead to severe problems when applying multiples, DCF methods and real option approaches to valuing entrepreneurial businesses.
Multiple approaches such as the ‘similar public company approach’ or the ‘recent acquisition approach’ attempt to draw conclusions about the value of the firm by looking at prices that were paid in the past for ‘comparable’ companies either in M&A deals or at the stock exchange. Comparable companies can hardly be found for entrepreneurial firms because of the uniqueness of their business model and the specific managerial expertise and networks of the founder. Therefore, multiples fail when valuing small, innovative firms.
In addition, the several variations of the DCF approach are not convincing for the purpose of valuing small, innovative firms. DCF methods aim to calculate the market value for the firm which is valid in a perfect capital market in equilibrium. However, the premises of a perfect capital market are not met at all in the case of entrepreneurial businesses, as mentioned above. As a consequence, DCF approaches fail when valuing small firms. They are based upon the CAPM and therefore cannot be applied under the assumption of an imperfect capital market.
The real options method computes the value of the firm as the sum of a basic value (calculated by the DCF method) and an option value that is generated, inter alia, according to the models of Black and Scholes or Cox et al. Both basic and option value are therefore calculated assuming a perfect capital market which is not met in the reality of entrepreneurial businesses. Despite this severe weakness, there are surprisingly many proponents of the real options method who claim that the approach is particularly adequate for valuing small, innovative firms.
—Gerrit Brösel, Manfred J. Matschke, and Michael Olbrich, “Valuation of Entrepreneurial Businesses,”
International Journal of Entrepreneurial Venturing 4, no. 3 (2012): 241-242.
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