Valuation is the most important concept in finance, and something that every business owner should know something about. At the end of the day, each of us is in business to create value. Your company’s value captures nearly everything about your business in one, easy-to-understand number.
Valuation has a reputation for being boring, abstract, and complex…and to be honest, it tends to be. But fear not, I’ve boiled it down to three key concepts that make it easy.
- Valuation Methodology
- Common Pitfalls
- Value-Based Management
We’ll start with a simple definition – valuation is the price that a reasonable person would pay to own the future cash flows of a business less any debt owed plus all cash on hand.
There are a number of different ways to calculate the value of a business, but the two most common methods are the discounted cash flow and market multiple methods.
Under the discounted cash flow method, or DCF for short, you try to estimate the business’ future cash flows and determine how much they’re worth today.
The important thing is that we now understand that when using the discounted cash flow method, the value of your business is based on two things: the cash flows you think you’ll generate in the future, and the reasonable rate of risk-adjusted return you require to earn on those cash flows.
Once you estimate the cash flows and determine an appropriate discount rate, you simply utilize the present value concept to calculate the value of the cash flows. Then, you subtract all of the debt that you owe and add in any cash on hand to arrive at the value of the business.
Another, more easier to calculate approach to valuing your business, is called the market multiple method. In this method we don’t worry about projecting cash flows or figuring out what a reasonable rate of return might be. Instead, we look at businesses that have actually sold and compare the sales price to a metric in the business, such as revenue or earnings. Let’s look at another, slightly simpler example.
Let’s say that you own a restaurant and you want to know how much it’s worth. You know that a similar restaurant in your city recently sold for $1 million dollars and had about $200,000 in earnings. The market multiple for this business is calculated by taking the sales price of $1 million and dividing it by earnings of $200,000. In this case, the multiple is 5 times earnings.
So, using this estimate, you’d simply multiply your earnings by 5, subtract debt and add cash to figure out what your company might be worth.
Now there are benefits and drawbacks to both approaches. The discounted cash flow model, while complicated, does a really great job of capturing the specific story of your business, and more importantly the direction you think it’s headed. The problem is that it’s really hard to predict the future accurately. It’s even harder to figure out what a reasonable rate of return would be for your business.
The market multiple approach, on the other hand, does a pretty good job of estimating what people are actually paying when buying businesses. Unfortunately, it doesn’t take into account the specifics of your company and isn’t forward looking.
Best practice is to use both and weight them according to how confident you are in each. That way you get the best of both worlds and can arrive at a reasonable value for your business.
Are you still with me? There are a number of pitfalls that you, or any professional for that matter, can run into when valuing a business.
First and foremost, it all comes down to assumptions. How risky is your business? What do you think the future holds? All of these are essentially guesses. The trick is to spend enough time thinking through each and have a reasonable justification for any assumption you make.
Second, valuation is subject to the garbage in, garbage out principle. If the financial inputs you use are inaccurate for whatever reason, then your value won’t be accurate. Many times a company’s income statement contains personal expenses or executive compensation that isn’t in line with the industry, or rent that is above or below market rates. In order to arrive at the most precise value for your business, you’ll need to make adjustments for each of these items in order to arrive at a realistic, sustainable estimation for your financial performance.
If you can’t make adjustments regarding unusual expenses in your financials, it isn’t the end of the world. The resulting value will simply be a strategic value, rather than a precise value, meaning that it will provide you with the magnitude and direction of the value of your business.
Obviously, if you are selling your business, valuation is extremely important. However, valuation can and should be used as a powerful driver of how you manage your business. The purpose of this estimated value is to track the effectiveness of your strategic decision making process and to provide you with the ability to track performance in terms of estimated change in value.
This helps you to take a holistic look at your business and make decisions that are highly impactful for your bottom line. It allows you to understand the subtle dynamics of your business and avoid unforeseen consequences of seemingly reasonable decisions. A value-based management approach will set you apart from your competition and dramatically change the way you look at your company.
So to sum up...
1. Valuation is the most important concept in finance. Every business owner should know how much his or her business is worth.
2. The methodology can appear to be complex, but it ultimately comes down to the present value of expected future cash flows and transactions that are actually taking place in the market.
3. There are a number of pitfalls you should avoid when valuing your business
4. Value-based management gives you a holistic view of your business and helps you make the most impactful decisions.
I hope that helps clear up some of the mystery surrounding valuation. We’ll continue to dig deeper into this topic in upcoming columns.