Learning simple financial formulas and applying them to know the value of your business
Owners, investors and stakeholders of privately held companies need to know what their business is worth. Valuation is required not just when selling a business; it is needed to better understand how to develop appropriate strategies and tactics that will maximize the variables that drive business value. There are, in fact, many instances when a valuation exercise is required to establish the value of a company:
- An investor or entrepreneur may decide 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 any new investor receives in the company.
- An existing partner or partners may want to buy out the other partner’s interests in a company.
- An owner might want to exit the business, change direction or possibly retire.
There are all sorts of accounting and financial formulas that can be applied here and expert opinion to be sought, but to provide insight and context we will explore this important theme in a way that should be understandable to anyone running a small or medium-sized business.
Factors that affect business valuation include profitability and growth potential, the uniqueness of the value proposition and the existing provable customer base.”john lincoln, author
Signifi cant factors that affect the valuation of a business
Valuations reveal what the market thinks of a company, its management and strategy, its financial position and its prospects. 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 and the existing provable customer base. Other factors that are often not that obvious include 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.
Aspects like whether the business is in a defensive or growth phase in its market, sector drivers such as manufacturing costs, production volumes and sales prices and the impact these have on cash flow, also need to be taken into account. For start-ups that have not generated any revenue and those that are still in the
development stage, a key consideration includes the stage of development of technology. Valuations of start-ups vary significantly when a prototype is in the development stage to a beta testing phase, to a stage when customers are actually willing to pay and use a product or service. This noted, every business valuation follows some basic principles:
- Every business is valued based on its growth potential. Growth is fundamental for any business. Without the potential for growth, there is really no reason for anyone to invest in or buy a business.
- Business investment capital comes from two sources. Investment capital comes from investors investing money in the business and from borrowings. Therefore there is a cost of capital to consider – one is the opportunity cost of returns forgone from other investments, and the other is the actual cost of borrowing.
- Profi ts provide the only real returns. The profits generated from a company can be reinvested to grow the business, used to pay off debts, or used to reward the business owners, investors and stakeholders with dividends. These parties and/or the potential buyers of the business can invest their money somewhere else or in the stock market and can expect some reasonable returns, so the profitability or future profitability is the single biggest factor of any business.
- There is a time value of money. A $100,000 sum paid at end of 5 years is not the same as if it is paid today, because some safe investments in the market or depositing the money in a bank, would produce some level of reasonable returns.
- Cash is king. For almost all public companies, less than 10% of their market capitalization can be explained from the expected cash flows generated during a known planning period of say, five years. Trying to predict anything beyond a five-year business planning horizon has too many uncertainties. 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.
This is done by estimating the value of the company’s assets, but as assets are used to generate revenues this often under-estimates a growing business. Conversely, if a business has a large asset base but does not generate much cash, then its valuation would be lower than other more cash-generative companies.
There are three well-known asset-based valuation methods:
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 to be liquidated and sold.
Market comparable valuation
This is difficult as no one business is exactly the same. The intrinsic value of a business can only be understood by going beyond just comparing valuations of other comparable businesses in the same industry sector.
In this method, the value of comparable companies sold is divided by the earnings of those companies to derive a multiple which can be used to determine value. In this valuation technique, a company’s current earnings are multiplied by the multiple factors to determine the value. 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 other factors actually 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 most 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 the sale of other similar businesses.
Normalized earnings method – This is similar to the earnings multiple methods but it adjusts the earnings for ‘unusual’ items like the owner’s salary or normalizing the earnings impact for extraordinary events that affected the earnings, like natural disasters or fires and others.
Cash fl ow-based valuation
This is one of the most commonly accepted methods of valuation as it takes into account the value by determining the cash-flow streams of the company and its 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 are both 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 money if it is invested in other investments, as well as the borrowing costs. The tax benefits for the interest paid on 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 Sage of Omaha, and famous American entrepreneur, suggests, it is important that business owners and investors think seriously about their accounting practises and methods if they have plans to sell their interests in a business.
- Make sure that the financial records are impeccable, well managed, traceable and audited by reputable firms.
- Get experts to advise and help: Do not underestimate the value you might have to forgo if you do not have proper and auditable records.
- Ensure that business growth is sustainable and explore new ways to continue on a growth path.
JohnLincoln.one –The business growth hacker