Surprised? Then consider a typical situation calling for a business valuation – a company put up for sale. Business owners are proud to discuss the past track record of the business and especially how much money they were able to make.
Business value is in your dreams
Business investors and buyers look at the company from a different perspective. For them the question is about the expected future earnings. Historic track record is useful to the business investor only as a guide to help with the income forecast. The money anticipated to land in the bank is why the business buyers are even interested in acquiring a company.
Business value is in the eyes of the beholder
Think the past earnings are a reliable guideline for future income expectations? Not necessarily. Consider a Silicon Valley classic case of a technology start-up being acquired by a Fortune 500 public company. Odds are the real reason behind the acquisition is to get access to the cutting edge technology and top engineering talent. It’s an asset sale, basically.
Once the Fortune 500 company completes the acquisition, things swing into gear. The start-up is transformed into a brand new business unit and changed beyond recognition.
Business value – reaching for the stars
If you think about it, the forecast of future earnings made by the Fortune 500 acquirer is beyond the reach of the start-up acting alone. The public company has at its disposal the market access, established distribution infrastructure, customer loyalty, capital, and economies of scale the start-up could only dream of.
The link between business value today and future earnings
So far, so good. But how do you figure out what the business is worth today with all those future earnings looming nicely on the horizon? In fact, the business valuation toolbox has just the valuation method to do the trick. The discounted cash flow technique lets you establish the connection between the future earnings forecast and what the business is worth in present day dollars, right now.
The discounting magic needs one more key input from you – the discount rate. This number represents the risk associated with the business. Remember, the money has not yet landed in your bank account. The expectation of income could disappoint if the company falls upon hard times and hits unexpected difficulties down the road.
The discount rate essentially captures the risks inherent in future expectations – not getting the money when you expect it, falling under the rosy earnings forecast, or perhaps not getting a penny at all.
Business valuation and risk assessment – leave no stone unturned
Number crunching with the discounted cash flow valuation method could prove addictive and, somewhat disconcertingly, misleading. This happens when you omit some key anticipated business risks while creating your earnings forecast. Start-ups like to think of themselves as poised to dominate the world. A pile of money is just around the corner.
Then the reality sets in. It turns out the competition is not sleeping after all, and production delays are a real setback. Customers may be skittish about adopting new products from an obscure young company. Or the market becomes dominated by a few well funded competitors.
So the takeaway is this – you can run your business valuation based on future income expectations. Just make sure your forecast captures the business risks your company is likely to face.
Whenever the subject of business valuation comes up, the notion of valuation multiples is sure to follow. Business people and professional appraisers are quick to point out their favorite valuation multiples for a ballpark estimate of business value.
Business sale comps – market barometer of value
What is behind the popularity of these valuation tools? In short, the widely shared belief that the market is the ultimate judge of what a business is worth. All valuation multiples are derived from the market place. They establish a relationship between the business selling prices and well known financial performance metrics.
Business people tend to have their preferences when it comes to valuation multiples. The common ones are these:
Key Question: what price can the business sell for?
In order to figure out business value, you could expose the company to the market to see what offers you attract. That’s a highly labor intensive and expensive proposition if all you want to do is to establish the value of the business.
Absent direct market tests like this, the next best thing is to compare your company to similar companies that have actually sold recently. Let’s assume you can get your hands on the business sale prices and financial statements of several companies in your industry and your specific market. Now you can calculate the valuation multiples from these comps and use them to estimate what your target company is worth.
Fair market value – the going rate for business selling price
The notion of fair market value is what makes such comparisons possible and highly useful. Market participants, i.e. business buyers, investors, and business owner sellers tend to be smart people who bargain in their best interests. The result of business sale deals closed by these intelligent people is always a compromise. You give and take to get what you want.
As a result, the market for business sales sets an equilibrium of sorts for the going rate of a given business. The formal name for this is the company’s fair market value.
Using valuation multiples from similar sold companies gives you the tools to get at the fair market value of your business without actually going through the motions of trying to sell it.
Where do valuation multiples come from?
So far, so good. But what options do you have to get at reliable business sale comps? There are several ways to go.
Source No 1: Past business sale transactions
If a privately owned company sold in recent past, the price paid in such past transactions is a decent indication of its current business value.
Source No 2: Guideline public companies
Another approach is to look at the published valuations of publicly traded companies in your industry sector. Many mid-market private businesses are quite comparable to smaller public companies in operational and financial terms. There is one big difference though. Shares of public companies sell on the open capital market. On the other hand, a privately owned company rarely if ever offers its stock for sale. Such sales are typically reserved for accredited investors through carefully orchestrated private placements.
Since investors abhor stock that cannot be readily sold, they set a cap on what the private company is worth. The difference is known to business appraisers as the discount for lack of marketability or DLOM for short.
You can thus develop valuation multiples from similar public companies as follows.
First, calculate the multiples from the known valuations and financial performance of guideline public companies.
Next, discount the valuation multiples thus obtained by the appropriate DLOM number.
Source No 3: Private business sales
You can also research the results of private business sales in your market. Direct comparisons to companies like yours are a good way to assess your business value. Be careful when selecting business sale data for your comparisons, though.
Most of the private business sales that surface are reported by business brokers. Since brokers act as business sellers’ advocates, they may overstate the financial performance of the companies they represent.
Putting the best foot forward when marketing a business for sale is just a step away from exaggerating its financial track record in order to get the top business selling price. Caveat emptor is the name of the game when gathering private business sales data.
This may be obvious to the professional appraiser, but many business people often wonder – why are business earnings forecasts such an essential part of business valuation? Shouldn’t a business be valued on its historic financial performance record?
Why do a business valuation?
Think about a typical situation in which a business needs to be valued – a business sale. An established business would undoubtedly have a solid track record of financial performance. Even if the receipts come from the proverbial shoe box, the company’s CPAs work hard to assemble detailed financial records to file taxes. So the business owners can turn either to their bookkeeper or accountant to get a copy of the income statements and balance sheets dating back a few years.
Business value is in its future earnings
The business buyer can glean quite a bit from the historic financials. But a business is never bought for its historic earnings. If you are buying a business, you are after the future earnings you can expect to get.
This expectation is key – the business buyers do not benefit from past earnings – only from the future ones. The expected money is not in the bank yet, so the business buyer needs to estimate what the business can produce going forward.
As you can see, the business buyer is really interested in what the business will bring in the future. Hence, the need to forecast business earnings.
Business risk – the second key to business valuation
Since any forecast is uncertain, you also need to estimate business risk. In business appraiser’s terms, your business valuation begins with forecasting business earnings and assessing the company’s risk in the form of discount and capitalization rates.
Take a close look at the workings of the venerable discounted cash flow method. This esteemed income-based valuation technique lets you calculate the business value directly from the earnings forecast and the discount rate. That’s right, the expected future business earnings and risk estimate are the inputs that drive the business valuation result here.
When in doubt, run what-if business valuation scenarios
Sure, no one has a crystal ball, so all future expected earnings are an educated guess at best. If you have doubts about the accuracy of a given earnings forecast, take a look at the underlying assumptions. What may seem a reasonable income stream under one set of assumptions may appear unfounded if the assumption set is changed.
Professional business appraisers have a trick up their sleeve when dealing with particularly challenging business valuation situations. If a single earnings forecast seems questionable, the business appraiser generates several, one for each set of assumptions.
Imagine a business that needs a government approval to launch a new product line, such as a medical equipment manufacturer. If the government agency, for example the Food and Drug Administration, grants the approval early on, the company can enter the market and quickly ramp up its revenues with the cutting edge products.
If, on the other hand, the FDA drags its feet over the approval, the company’s product introduction stalls, and the revenue outlook may look less promising.
You can’t tell for sure which scenario will prevail, so you cover your bases by creating two distinct earnings forecasts. You then use each forecast numbers to calculate what the business is worth today, in present day dollars.
You can further express your opinion of business value by assigning the weights to each business valuation result and calculating an average based on the two expected outcomes. This weighted average number represents your current thinking about the business value.
Thinking of valuing a company in the telecommunications industry? Consider some key industry stats:
This large and highly diverse industry sector is classified under the NAICS code 517. In the USA there are some 50,600 telecom companies competing across a broad spectrum of product and service offerings. The industry as a whole generates a hefty $545.5 billion in annual revenues. The industry sector total employment is around 1,134,500 with a revenue per employee of $481,000 per year. The average telecom business does about $10.7 million in business annually and employs a staff of some 22 including technical professionals and administrative staffers.
Over 28,000 of companies in the telecom industry have 1 to 4 employees on their payroll. Of the total of over 50,600 firms less than 5,600 have more than 50 employees.
Where are the telecom businesses found? In the US, the highest density of companies in this industry sector is in California, New York – New Jersey, Texas, Florida, Washington DC, and West Virginia. Of course, just about every geography has a number of successful telecom firms providing a broad range of services to customers around the world.
Business valuation of telecom companies
Telecom industry is very competitive and successful businesses are highly sought after as acquisition targets. Selling prices of such companies are used as an indicator of market values for similar businesses.
You can compare a target telecom company to its sold peers by calculating the ratios of business selling prices to a number of financial performance metrics. The ratios of selling prices to financial performance figures are known as valuation multiples. The multiples so derived help you develop an idea of what a given telecom company is worth in the market place.
Business valuation of a telecom company – an Example
To show you how this works, let’s pick a middle of the road telecom business with an annual gross revenue of $10 million and inventory of $1 million. Next, we choose a set of reasonable valuation multiples and crunch the numbers. Here are the results:
Business value ($’000)
Average Business Value
Note that we have added the value of inventory to the result of multiplication. This is common when valuing businesses with widely varying inventory levels.
Telecom Company Valuation
Recently observed business selling prices give you the real world data on which to base your own valuation. There is nothing more credible than the prices paid for similar businesses. You can calculate a number of other valuation multiples such as those based on net profit, EBITDA, or business assets.
If you are valuing a business using the income based methods, creating a viable earnings forecast is essential. Your business valuation result depends on your ability to accurately predict the income stream and assess business risk going forward, not an easy task.
What do you value – Business highfliers or cash cows?
No one has a crystal ball in business. Any number of circumstances can affect business prospects and have a material impact on its earnings. On the other hand, some companies operate in a protected niche mitigating uncertainty and ensuring the profits for the foreseeable future. These are the famous cash cow businesses, an investor’s dream come true.
So while an earnings forecast can be credible for a cash cow business, the same approach may fail when estimating future earnings for a high tech start-up.
What options are out there to create a reliable set of earnings forecasts for a company? The answer is, unsurprisingly, it depends.
Linear regression model for cash cow businesses
For the cash cow business that you expect to continue running much the same as in the past, an excellent earnings forecast model is the well-known linear regression. Under the assumption that historic trends accurately predict the future, you essentially project business revenues and expenses based on the company’s historic track record.
Visualize plotting the revenues and expenses on an X – Y chart. Draw a straight line through the historic data set into the future to read off the anticipated numbers. This is the linear regression model in a nutshell.
But what happens with the new businesses without a reliable history of earnings? Or a company undergoing significant changes such as new investment or change of business strategy? In such cases historic trends may be either non-existent or plain misleading.
Sales driven earnings forecast models
Time to roll up the sleeves and get to work developing a more realistic earnings forecast model. Most such models are sales driven. Based on the management’s plan and knowledge of the business and its industry, you create a revenue forecast.
Let’s say the company is expected to generate a certain level of sales in the next year, then continue to grow the sales level at 5% per year. Don’t forget to check the industry sector growth trends so as to stay within a realistic range of possible growth rates.
The business expenses, both cost of goods and fixed expenses can then be forecast as a percentage of revenues. This gives you the gross profit and net income forecast. You can use the same approach in order to estimate the future needs for current and fixed assets investment such as working capital, property, plant, and equipment, and financial capital.
Uncertain business prospects – creating best case, worst case earnings forecasts
The situation may get really interesting if you anticipate several likely outcomes for the company. Let’s say there is a possibility of substantial regulatory compliance outlays that may become a drag on business earnings. Or a government agency approval needed to enable the company’s new product sales.
You can create several what-if earnings forecast scenarios to capture each potential future outcome. Early approval creates the opportunity to generate high level of sales early on. Your earnings forecast should reflect this scenario. Higher business earnings in early years are sure to translate into higher business valuation result using the discounted cash flow method.
Conversely, delays in product introduction or pricing pressures from competition are likely to depress the earnings forecast. Re-run your discounted cash flow valuation with this cash flow stream to see how the business value changes.
Business valuation as a strategic value building tool
Having several business valuation results for each anticipated scenario gives you a range of values for the business. Remember that the discounted cash flow valuation gives you the present value, or what the business is worth today. You have translated future expectations into a set of numbers relevant right now.
Such what-if valuation analysis is extremely helpful if the business management must make critical decisions on their strategy. Don’t like the numbers? Now is the time to review your business strategy and make value enhancing changes.
This group of business assets is of increasing importance to business value creation. Here is the short list:
Trademarks and service marks
Website domain names
Trade marks and service marks are generally protected intellectual property. Businesses often seek their registration, such as the Federal trademarks issued by the US Patents and Trademarks office (USPTO).
Website domains are subject to domain registration rules. They often are a hotly contested commodity as businesses increasingly seek valuable online presence.
Non-compete agreements are enforced as commercial contracts that enable companies to operate in a protected market niche.
Intangible assets are sources of income
Importantly, these valuable intangibles can be licensed to others in exchange for a royalty income stream. Imagine the value of well known brands in generating business earnings. Customer recognition of some trademarks may be worth a fortune because it can generate additional income from their name while the rights to the company’s own products and services are protected.
In a business M & A transaction, such brand names are broken out into a group of intangible assets alongside business goodwill. During business valuation, each of these intangibles has a value assigned to them.
Business intangible assets may have a long life span
Historically, such intangibles were deemed to possess a limited life span. These days, business people recognize that trade name values actually grow over time. Thus, many trademarks may be seen as having an indefinite life. The earlier amortization rules do not seem to be appropriate for such assets.
Impairment test for handling intangible asset values
The Financial Accounting Standards Board (FASB) now provides for an impairment test when handling the marketing intangible asset values, similar to handling business goodwill.
What this means to you, is that the business intangible assets must be valued under the new rules. However, you do not need to write them off, unless the asset has a clearly defined life. This would be the case for term non-complete contracts which need to be amortized accordingly.
Business valuation is a constant challenge for the business people and professionals alike. While many security analysts do not have the accounting background, they often engage in valuing companies.
Professionally managed firms, especially public companies, must adhere to the consistent financial accounting and reporting rules such as the GAAP mandated in the US by the Securities and Exchange Commission (SEC).
SEC discourages private discussions between the public company management and independent security analysts these days, so digging up additional information beyond the filed GAAP financials is not easy. Most significantly, the company’s financials disclosed to the public do not provide much guidance on the values of company’s intangible assets.
From the asset approach perspective, business intangible asset value is potentially a very significant contributor to the value of the business enterprise. So how can an analyst estimate the value of a business in the absence of information on the valuation of the patents and trademarks, internally developed technology, skilled workforce, distribution channels, and customer lists?
If you are skeptical about the ability of a valuation expert to come up with an accurate business valuation without such information, you are not alone.
Many seasoned analysts know this and defend their view of business value by claiming the understanding of the key value drivers for the target companies. In other words, an experienced analyst develops an insight into the underlying business assets that are not explicitly valued in the disclosed financial and operational statements.
Less experienced analysts could arguably be swamped by the flood of data on a company and fail to make sense of all the ‘moving parts’. They feel that the accounting statements they have access to are about all they can handle in order to estimate business value.
So there you have it. Analysts tend to develop their opinions based on both the information available as well as their ability to glean the additional details on what creates business value. The conclusion is only as good as the credibility of the business appraiser.
Fundamental to the business valuation process is the need to make assumptions about future events. What the business is worth today depends upon future cash flows. These future business earnings are a function of business future performance, financially and operationally.
Business value is about the future earnings and risk
No matter how you slice it, you need to take a leap of faith and make some critical assumptions about how things will turn out.
Do errors of judgement occur? Yes, indeed. How useful your business appraisal is depends in large part on how well you can foresee the future for the company.
Devil in details – business valuation depends on your assumptions
Both the business appraiser and business clients reading the valuation report must take ownership of the process here. As a business person, you should read the entire report, not just the business value conclusion section. Otherwise, you may miss important assumptions that qualify the valuation result. The body of the appraisal report should tell you how these assumptions have led to the business value number at the end. Equally importantly, you can spot how sensitive the valuation result is to the key value drivers your business appraiser has considered.
In business valuation, the assumptions drive the results. If the assumptions are seen as reasonable by the intended readers of the report, the conclusion should come as no surprise.
If, on the other hand, you find the business valuation conclusion troubling, go back to the assumptions made at the outset. If still in doubt, ask your appraiser to clarify the assumptions or run what-if scenarios under alternative expectations to assess their effect on business value.
If you are working on a business appraisal, a big part of the analysis is reviewing the industry outlook. In many ways, the industry in which the business competes is far more important than the general economic situation. If you are valuing a strong company in a growing industry, its valuation is likely to be higher than that of a failing business that operates in a shrinking industry sector.
As part of your business valuation, you need to determine the overall industry growth potential, and the ability of your subject business to compete successfully. Some of the elements that should go into your analysis are the strength of the management team, the skill set of the key staff, financial condition of the firm, customer base, technology and other intellectual property assets, among other factors.
Your business appraisal report should outline clearly the industry sector and how the company fits into the competitive landscape. Business people and professionals reading your business valuation report should be able to gain a solid understanding of the risks faced by the company, its competitive advantages, and see how your conclusion flows from this thinking.
To make a compelling argument, you would need to provide a well researched description of the industry and the company’s plan on staying competitive. This is necessary in order to come up with realistic business valuation scenarios, such as the forecast of business earnings and assessment of the risks it is likely to face going forward.
Without this foundation, your valuation methods will merely generate unsupportable numbers. Remember the old adage, “Garbage in, garbage out.”
When it comes to business valuation, forecasting the business future financial performance is one of the most challenging, yet necessary tasks. Business value is about risk and returns going forward. Assessing how well you expect the business to do is at the core of establishing its value.
There are two ways to prepare the assumptions about the possible future financial performance of the company. One approach is for the business appraiser to come up with his or her best assessment. An alternative is to use the business management estimates.
Independent business valuations
If you expect the business appraisal to be subjected to serious scrutiny, objectivity of an independent business appraiser is key. This argues in favor of letting the appraiser do the forecasts of business earnings and expenses.
Rosy forecasts and overstated business value
Business management created financials are often rosy and based on aggressive goals. Many business people tend to underestimate the potential pitfalls that sharply limit the company’s ability to achieve such lofty objectives. This is especially the case when a company is facing serious headwinds currently, but hopes the coast will clear in the near future. More trouble ahead may well be overlooked.
The effect of these projections changes your business valuation result significantly. Take, for example, the discounted cash flow valuation method. The forecast of future earnings is a key input. If your cash flow forecast is unrealistic, especially in the early years, the value of the company will be overstated.
Unrealistic business valuation – uncomfortable questions
Valuations that are unexpectedly high are sure to generate skepticism from savvy business people and professional reviewers. An appraiser could state in the business valuation report that the assumptions of company’s management have been used in the analysis. The reader is put on notice, but is still left wondering why the business appraiser went with the management’s point of view.
Independent business earnings forecast – the objectivity advantage
If the business appraiser creates the earnings forecast from scratch, the readers of the business valuation report would likely expect a less enthusiastic but more sober set of assumptions. After all, business appraiser is not bound to endorse high expectations, but rather expected to provide a realistic measurement of what the business is worth.
Has the business appraiser covered all the angles?
The downside is that the business appraiser may not have the in-depth knowledge of the company to make the best projections. As an outsider, you may lack the understanding of the value drivers that can support the earnings growth the company’s management expects.
So what is the best approach? No clear answer exists. Perhaps close interaction between the experienced company management team and business appraiser is the best strategy.