Business Valuation: What’s it Worth?
Valuation is a prophecy of the future; hence, it lacks precision. Still, value has a clear logic. The relationship between risk and return on investment needs to be understood through the eyes of the investor. A smart buyer will look at your business and price it according to their perception of its risk. A smart seller will get an objective valuation done well before going to market.
Deals often fail due to a seller’s unrealistic price expectations or shock when they see the tax bill! Advanced planning gives you time to polish your gem before a prospective buyer or investor comes through your door.
Business Valuation 101
The valuation equation equals Cash Flow/Capitalization Rate. A firm’s cash flow is discounted by the risk of receiving that cash flow; higher risk means lower value. Growing cash flow is the more readily understood way to increase business value. Reducing risk is another, often overlooked, way to increase business value.
Business appraisers commonly use the “build-up method” to estimate various risk factors in a business. Risk is measured by the capitalization rate: think of this as a “risk score.” A higher risk score means investors want more return to compensate for higher business risk.
Small, privately-held firms typically carry more risk than public firms that trade on an exchange. The Private and Public companies listed below illustrate how the capitalization rate impacts value: both have the same cash flow and the same growth rate. However, the higher capitalization rate means an investor will pay less for the Private Co.’s higher perceived risk.
The purchase justification test below is a reality check on the subjectivity of the Build-up method. A banker wants to if cash flow is adequate to cover debt payments; a buyer wants to know what return they’ll receive on their cash investment. In this example, the banker’s debt coverage is 1.8; the buyer gets a cash on cash return of 5.8%; add the equity build up from debt reduction and the total return on cash is closer to 23%.
Failure to understand business value and taxation issues can be costly and time consuming. Another risk is the failure to have a documented process for shareholder buyouts, which are often unplanned, poorly planned, or forced by a trigger event.
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