Company valuations are arbitrarily decided by management or third-parties, but that doesn’t mean prospective investors shouldn’t take a closer look at their approaches while conducting due diligence. In fact, they should be doing it more than ever now that valuations are swinging up and down — fluctuating by billions in dollars — at a moment’s notice. 

When Beyond Meat, a maker of meat alternatives, went public, their value grew from from $1.5 billion to $3.83 billion the next day — making history with the biggest IPO pop in more than a decade (their value is now over $14 billion). In contrast, Pinterest, a digital scrapbooking site, has plans to go public this year and deflated its value by $3 billion. The potential upside of any investment depends on a company’s valuation, so prospective investors should think critically about what approaches are being used.

Understand the role of a company’s valuation 

Aswath Damodaran, a business valuation expert and finance professor at New York University’s Stern School of Business, said there’s a role for valuation at every stage of a company’s life cycle.

“For small private businesses thinking about expanding, valuation plays a key role when they approach venture capital and private equity investors for more capital,” Damodaran wrote in one of his books. “As companies get larger and decide to go public, valuations determine the prices at which they are offered to the market in the public offering.”

He highlighted that once established, company decisions on where to invest, how much to borrow, and how much to return to owners will be affected based on their perceived impact.

Consider what the fluctuating numbers mean

Dave Berkus, an angel investor, venture capitalist, and creator of the Berkus Method, a method that was created to de-risk early-stage investments, said that fluctuating numbers could signal different things — depending on the stage of the company.

“A down round for an early-stage company is perhaps a sign that the company isn’t going to do well in the end,” Berkus said. “There are times when investments are worthwhile and at least lesser risk than earlier investments. I’ve made a number of those kinds of investments, and they take longer to bake or get ready for sale or go public, but those investments have a higher multiple because of the fact that this a down round.”

Berkus added that a down round for later-stage companies, such as Pinterest, is a sign that investors “got ahead of themselves in valuation.”

“Remember that these investors often purchase either for ‘prestige’ or with instruments, such as preferred shares, that give them protections and profits — even with a reduction in valuation of the common shares at IPO,” he said.

Review the company’s valuation approaches 

Jordan Gillissie, the founder and CEO of Equifund, an investment platform that delivers vetted, early-stage investment opportunities, said that reviewing the company’s valuation approach is essential.

“There are a handful of ways private companies or institutions determine a valuation,” Gillissie said. “Internally, we use multiple approaches to create a blended average, such as the First Chicago Method with the Balanced Scorecard Method or Berkus Method.”

He suggests finding this information by reviewing the company’s S-1, a form that’s filed with the US Securities Exchange Commission (SEC), before being listed on a national exchange.

“You can find a company’s S-1 by going to the SEC’s EDGAR website, which will contain detailed information,” he said. “For example, Pinterest’s updated filing shows they used the income, market, and probability-weighted expected return approaches and how they were applied. Prospective investors should review these approaches and evaluate whether or not the math makes sense,” adding that Equifund provides educational courses and insight reports on these areas.

Essentially, it’s prudent for prospective investors to investigate a company’s fluctuating numbers — even if it’s the latest tech unicorn to go public. Thankfully, the SEC’s EDGAR website and Equifund makes it easy to find the information they need to educate themselves on the due diligence process. The more that prospective investors investigate, the lower the risk and potentially higher upside.