What is the art of valuing your business?

I am sure most investors and owners that have small and medium privately held businesses have wondered as to what their business is worth.

I will try to keep this simple and not bother you with boring accounting and financial formulas but rather approach this in a way that is understandable to any one running a small or medium business.

Understand how a business is valued will help small business owners and investors in SMEs to develop strategies and tactics to maximize the variables that matter.

Valuation is required not just for selling a business. There are many instances when a valuation exercise is required to establish the value of a company.

–       An investor or entrepreneur decides to invest or buy into a business, rather than starting one from scratch.

–       An owner needs to establish the value of the company in order to contribute the appropriate number of shares to an Employee Stock Ownership Plan (ESOP).

–       A value is needed to establish the percentage of ownership that the new investors receive in the company.

–       A partner or partners who want to buy out the other partner/s interests in a company.

–       An owner who wants to exit the business and possibly retire.

This is one problem that has many approaches to it. Before I dwell into some of the gritty details, it will be useful to remember some guiding principles.

  1. Be sure of your motives beyond a windfall exit.
  2. There is no single best method to determine a business’s worth.  The best way is to compute the value using different methods and choose the best one.
  3. Both the buyer and the seller must be satisfied with the deal.
  4. Both the buyer and seller should have access to business records.
  5. Valuations should be based on facts, not fiction.
  6. Both parties should deal with one another honestly and in good faith.
  7. Set realistic and conservative expectations and know your cut off value points (whether you are a buyer or seller) so that you would be very clear in your mind, when a firm offer comes through. A business is only as worth as how much someone is willing to pay for it.
  8. Get expert opinion, but it is you who will need to decide in the end.
  9. Have a crystal clear view of the value blocks (both positive value enhancers and negative and potential value destroyers of your business)
  10. Create multiple scenarios of the valuation model.

Significant factors that affect the valuation of a business

There are many factors that affect the valuation of a business. They include the obvious ones like profitability and growth potential, the uniqueness of the value proposition of the business, the existing provable customer base and others.

Other factors that are often not that obvious include factors like tax credits for past losses, goodwill based on a company’s reputation in the market and proprietary processes and methods  and or patents awarded or pending that are not known or easily replicated.

For startups that have not generated any revenue and those that are still in the development stage, the key considerations include stage of development of technology. Valuations of startups vary significantly when a prototype is in development stage to a beta testing phase to a stage when customers are actually willing to pay and use your product or service.

Cash is king and growth matters!

Every business valuation follows some basic principles that you should always keep in mind.

  1. Every business is valued based on its growth potential. Growth is fundamental for any business. Without a growth potential, there is really no reason for anyone to invest or buy a business.
  2. Remember that the business investment capital comes from 2 sources. By investors investing money in the business and from borrowings. Therefore there is a cost of capital. One is the opportunity cost of returns forgone from other investments, and the other is the actual cost of borrowing.
  3. As a business owner, the profits generated from your company can be reinvested to grow the business, pay off your debt or reward your investors with dividends. You and the investors in your business or the potential buyers of your business can invest their money somewhere else or in the stock market and can expect some reasonable returns.
  4. There is a time value of money. A $1,000 paid at end of 5 years is not the same as if it is paid today, because if you had made some safe investments in the market or put the money in the bank, you can expect some level of reasonable returns.
  5. You may not know this, but for almost all public companies, only about less than 10 percent of the market capitalization can be explained from the expected cash flows generated during a known planning period of say, 5 years. Trying to predict anything beyond a 5 or a 10 year business plan time horizon has too many uncertainties and is not worth the paper it is printed on. So analysts use the growth factor to forecast the terminal value or the continuing value of the business. This terminal value or continuing value accounts for about 95% of a company’s market capitalization.  If you do not believe me, take a look at some of the largest and well known businesses in the world. Their revenue numbers are well known and reported and it is easy for you to check this.

Valuation methods

  1. 1. Asset based valuation

This is done by estimating the value of the company’s assets. As assets are used to generate revenues, this often underestimates a growing business. Conversely, if a business has a large asset base but does not generate much money, then the business is not worth purchasing!

There are 3 well know asset based valuation methods. They are

Modified book value technique – This method adjusts the company’s assets by looking at the historical value of the assets and adjusting this value to reflect current market values.

Replacement value technique – The value of a company’s assets are adjusted by deducting the cost it takes to replace or replenish the assets

Liquidation value technique – This is usually used in a forced sale situation and assessed as if the company has ceased operations and its assets are liquidated and sold.

  1. 2. Market comparable valuation

This is difficult as no one business is the same. The intrinsic value of a business can only be understood by going beyond just comparing valuations of other like businesses.

In this method, the value of comparable companies sold is divided by the earnings of those companies to derive a multiple to determine value. In this valuation technique, a company’s current earnings are multiplied by the multiple factor to determine the value of the company.

It goes without saying that the higher the growth potential or lower the implicit and explicit risks, the higher the multiple and therefore the higher the valuation.

In addition, a lot of ambiguous factors like a company’s vulnerability to market and economic risks (lower multiple), the over dependency on a few key people for the success of the business (lower multiple) and others determine the multiples.

Goodwill factors like a company’s reputation, unique location or customer relationships are often misrepresented when determining valuations using this method.

The common methods of doing market comparable valuation include:

Earnings multiple ratio method -   A company value is determined by multiplying the earnings to a multiple that is compared to sale of other similar businesses.

Normalized earnings method – This is similar to the earnings multiple method but it adjusts the earnings for “unusual” items like the owners salary or normalizing the earnings impact for extra ordinary events that affected the earnings like natural disasters or fires and others.

  1. 3. Cash flow based valuation

This is one of the most common and more accepted methods as it takes into account the value by determining the cash flow streams of the company and the growth potential.

In simplistic terms, the Free Cash Flow (FCF) which is the amount of cash generated by the business less the operating and capital expenditures and other reinvestments made and the growth potential of the cash flow is estimated.

These cash flows are then discounted in today’s  value by using a required rate of return which takes into account the opportunity cost of the money if it is invested in other investments as well as the borrowing costs. The tax benefits for the interest paid for the borrowings are also taken into account.

“Earnings can be pliable as putty when a charlatan heads the company reporting them” – Warren Buffet

As Warren Buffet, the Oracle of Omaha, and the famous American entrepreneur said in the heading above, it is important that SME owners and investors think seriously of their accounting practices and methods if they have plans to sell their interests in a business.

If you have business exit and retirement on your mind, make sure that you’re financial records are impeccable, well managed, traceable and audited by reputable firms.

Do not underestimate the value that you might have to forgo if you do not have proper and auditable records. Get experts to advise and help you.

Finally, always ask yourself if your business growth is sustainable and how you could make it sustainable. Otherwise, all that blood, sweat and tears that you put into your business might not pay off. Growth matters!

As Peter Drucker, the famous American management guru said “Erroneous assumptions can be disastrous”.

John.lincoln@gmail.com twitter @lincolnjc

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This entry was posted in Business Value, Decision, Management, SME, Strategy, Valuation. Bookmark the permalink.

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