You heard the old adage, ‘time and tide wait for no man’. None more apt than in business appraisal. You don’t have to go back a ways to see why. Remember the heady days of the Great Recession? Businesses were trembling in anticipation, markets creaked at the seams, and politicians spouted their usual platitudes and wishing it would all go away.
Admittedly, this was a cataclysmic event the likes of which we hope never to see again. But wait, what about the Great Depression of the 1930s and the collapse of the world stock markets? Clearly, even the rare events can and do recur.
The truth is, markets are living breathing organisms. Fortunes change, people enjoy the good times and run for the exits when the clouds gather. Investor sentiment is as volatile as a morning mist on a hot summer day.
Markets are volatile, business values change all the time
Political uncertainty, trade wars, hot wars, threats of economic instability all contribute to major shifts in how business people see the future. You can see this clearly in the public capital markets – people vote with their pocket books once they discern where the wind is blowing.
Now, no one is bigger than the game, your business included. If the risks mount, safer havens are a better bet for investors. Think government bonds with guaranteed coupon rates and repayment of the principal on time. Sounds a lot less risky than a company struggling to weather an economic storm.
In times of economic expansion, you can expect things to calm down, the risks to subside, and investors to crack their wallets open again with an appetite for business investment. Buying of existing companies in such times ramps up and prices paid express the investors’ optimism about the future.
Check the market pulse in times of change
Using the market approach to business valuation is an excellent idea in times of economic upshifts or downturns. You watch the M&A activity in your industry and spot trends as business buyers and sellers close deals. If your own business is comparable to the active market players, you can work out what it is worth on the market right now.
Business sale prices as indicator of fair market values
This ‘going rate’ business valuation is one of the biggest reasons market approach is so useful. All you do is watch the actual transactions, gather the selling prices, calculate the valuation multiples and estimate the value of your business.
The fair market value figure you get from this is a good indicator of what your business would sell for if you put it on the market. The winds of change can go with you or against you. In either case, knowing the way is half the journey.
In the complex world of business valuation keeping things simple may seem as a distant dream. Just think about the challenges faced in valuing a company: analysis of economic conditions, forecasting business earnings, assessing risk, choosing the right valuation methods and interpreting results that may puzzle the unwary.
With so many moving parts, it’s small wonder business valuations are often subjected to intense criticism. Industry mavens fret over the application of standards and ethical flaws perceived in some business appraisals. Business people puzzle over the results that don’t seem to make sense. Complexity born of necessity?
Not necessarily. For savvy business investors analyzing opportunities is second nature. They learn to sift through a pile of maybes by using tried and true methods that stood the test of time.
Income based business valuations cut to the chase by letting you focus on the core reason for running a business – putting money in your pocket. In addition to the amount of the cash expected to swell your pocketbook in the future, you would need to size up the risk. Risk in investment addresses this important question: how confident are you about getting the cash on time and in full measure?
Business valuation: risk and return are inseparable
So risk and return go hand in hand. The reason the income valuations work is because they match the two. Take, for example, the famous discounted cash flow method. You put your crystal ball before you and create a forecast of business earnings. To figure out the risk, you work up the discount rate. Now use the discounting math and the future expectations are translated into the so called present value. Witness the magic of sizing up your future expectations today.
Discounting vs capitalization valuations – the difference
The discounting math is known as multi-period. In other words, your forecast is done over several time periods into the future. The usual way is to predict cash flows for several years ahead, say 5 years. At the conclusion of which you make a leap of faith regarding the business value in perpetuity, known as the terminal value.
Instead of all this fancy forecasting for years into the future, all you need to do is divide an earnings number by a capitalization rate.
Great, but does this really work as well? In fact, it does, provided one little assumption holds true. The complex math of discounting reduces to the simple capitalization if your business earnings are expected to grow at a constant rate.
Cash cow business valuation – life is good
How relevant this is to you depends on the business being valued. Imagine a cash cow that keeps chugging year after year producing predictable, steady income. This is a perfect example where a single period capitalization valuation makes sense.
Valuing a technology company
How about a high flying tech start-up? These companies may disappoint you in a jiffy. High earnings one year, a crash the next. Better stick with the complex discounting valuation to make sense of this roller coaster.
As the saying goes, the devil is in the details. Keep it as simple as you can. Just don’t skip the steps in your business valuation.
Putting the business on the market? Valuing the business to set the right asking price or make an acceptable offer is half the battle. Stray but a little and the deal is bound to go south.
You have a choice of three approaches to business valuation, namely the asset, income, and market. Of these three ways, measuring business worth based on its income goes to the core of why businesses are created – putting money into the owners’ pockets.
Smart business people always look for the best opportunity to invest their hard earned money. Figuring out if you get the financial returns for all your trouble is what income valuation is all about. You can review a number of business opportunities and measure their value by comparing their ability to generate income at an acceptable level of risk.
Risk in investment is the other key element of measuring business value. If you anticipate some income in the future, how sure are you of getting it on time and in full measure? This depends on how risky the business investment is.
In formal business appraisal terms, you need to come up with both the estimate of future earnings and the measure of business risk, usually expressed as its discount or capitalization rates.
For a given level of expected earnings, the higher the risk, the larger the discount or cap rates and the lower the business value. Put another way, a riskier business needs to generate higher earnings to justify your investment. You could decide the risk is just too high and put your money into a different business opportunity that promises perhaps somewhat lower but more predictable returns.
How to calculate business valuation
Income based business valuation can be done two ways. You can calculate the so called present value of the company by discounting its earnings. As an alternative, you could capitalize business earnings by dividing them by the capitalization rate.
Business valuation by discounting its cash flow
Generally, businesses with widely fluctuating earnings are best valued by the discounted cash flow method. This lets you focus in on the effect the earnings in each time period have on business value.
Single period capitalization methods
If the company is the proverbial cash cow with steady cash flow thrown off year after year, you can get pretty accurate valuation by the simpler capitalization methods.
What if you can envision a number of scenarios in the future that affect business earnings and risk? Things like competitive pressure, new product introduction, or regulatory approval that’s on the horizon?
Assessing the worth of your business
You can assess business value in each case by running a separate what-if valuation calculation. Generate your income forecasts and assess discount and cap rates for each possible outcome. Then calculate your business value and assign a weight to the result based on the likelihood of each scenario actually panning out.
This gives you either a single business value number or a range of values from low to high. If you have done your homework well, the actual business value will fall somewhere in the range.
This valuation method is formally known as the capitalized excess earnings technique. The idea behind the method is that superior business performance goes hand in hand with above average profitability. Established companies that excel at their game tend to command the loyalty of customers who are less price sensitive than the comparison shoppers ready to jump on the best deal from anyone.
Superior earnings indicate business goodwill
Higher earnings also underlie the concept of business goodwill. The idea is that business value is higher than the sum total of its assets. In a highly profitable company, the total business value is above the sum of its parts. This difference is business goodwill.
Measuring business goodwill is where the excess earnings come in. Business owners are viewed as investors who supply the capital needed to operate the company. As investors, they would expect a fair rate of return on this committed capital.
Top performing companies possess lots of goodwill
But highly successful companies do one better. In addition to providing their investors with a fair return on their money, these great businesses throw off additional earnings. To measure business goodwill, you would capitalize these excess earnings by the company’s capitalization rate.
Goodwill is part of total business value
The total business value then is the sum of the company’s key operating asset values plus business goodwill. The beauty of the capitalized excess earnings valuation method is the ability to translate exceptional performance into business value as the sum of invested capital assets and the intangible business goodwill.
Here is to the business owners with vision and dedication to create highly successful companies. They don’t rake in excess income, they produce excess earnings and a lot of valuable business goodwill.
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.