Business Valuation: What’s it Worth?
Valuation is prophecy of the future. Hence, it inherently lacks precision. Still, fundamental value has a clear, understandable logic that we can help you better understand. Would you buy or invest in any asset without understanding its value? Would you trust your life’s work to a back of the envelope calculation or simple formula? A smart buyer will look at your business as an investment and price it according to their perception of its risk. We can help you understand how risk and return relate to the valuation equation so you can help strengthen your business prior to any type of negotiation. Advanced planning gives you time to polish your gem before a prospective buyer or investor comes through your door.
Business Valuation 101
Privately held firms don’t have a daily quote like their publicly traded counterparts. This lack of liquidity along with a lack of consistent financial reporting make privately held firms a more risky investment; therefore, the return expectation on these assets must be higher to compensate a potential buyer or investor. Risk and return are key concepts for you to understand.
The valuation equation in defined as Cash Flow/Capitalization Rate (or a discount rate). This equation simply takes cash flow and discounts it by the risk of receiving the cash flow. The numerator, cash flow, is a function of growth and margins. In a well managed firm, revenue growth will generate profits that grow with revenue, or better if they have a scaleable business. Revenue growth that isn’t accompanied by rising profits can indicate several problem areas. The denominator, capitalization rate, is often an overlooked area for value improvement.
For example, firms with high dependency on one key person, high customer or product concentration, or lacking recurring revenue streams are considered riskier than firms with management depth, diversified customers, and multiple products. You can think of the denominator as a “risk score.” A higher risk score means investors want more return as compensation for the risk, which lowers the value of the cash flow. Business appraisers commonly use a method that “builds-up” the risk rate by examining multiple factors. The example below illustrates the concept. The Private and Public companies both have the same level of cash flow (a simplifying assumption to illustrate the risk concept) and 3% growth rates. However, the return expectation required to compensate for the Private Co.’s perceived risk is much higher at 17.0% (vs. 7.5% for the Public Co.). Capitalizing the same $2.2 million of cash flow by the higher capitalization rate generates a much lower valuation. In reality, public companies tend to trade at much higher valuations.
The purchase test below is a reality check on the subjectivity inherent in the Build-up method. A banker wants to know how much cash flow will 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%; when you add the equity build up from paying off the debt, the total return is closer to 23%.
In reality, valuation is one part science, one part subjective judgement. Normalizing cash flow and quantifying the risk factors is based upon theory and a series of subjective judgements. Depending on the size, scale of operations, and strategic position of the company there are multiple value drivers that may need to be understood and addressed. Cost of debt capital is usually observable; cost of equity is a harder to define number simply because it must take into account qualitative factors that are not easily quantified. Some issues can be remedied quickly, while some may require 3-5 years to realize the full potential for creating a transferable business.
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