Can you use financial ratio analysis in business valuation? If done correctly, this could be a helpful adjunct in your valuation. Specifically, reviewing financial ratios could help you spot the company’s strengths and weaknesses, and compare its performance to industry peers.
Here are the major groups of ratios to consider in valuing a company:
Short-term liquidity ratios such as current and quick ratio
Activity ratios including the inventory and accounts receivables turnover
Risk analysis figures such as business risk and degree of operating leverage
Balance sheet ratios indicating leverage and equity to asset ratios
Fixed charge coverage ratios, indicating sufficiency of cash flow to cover debt service
Return on investment ratios such as return on total assets and equity capital
You can take advantage of the financial ratios in your business value analysis in a number of ways. Selecting valuation multiples in calculating the company’s market value is one area. The multiples are typically calculated from a data set based on several comparable companies. Riskier businesses tend to be assigned lower valuation multiples, while the firms with better financial performance could command higher valuations.
If your subject company compares favorably in terms of key financial ratios, its value is likely to be at the high end of the range. For example, consistent, stable history of earnings is a good justification to pick higher valuation multiples based on EBIT or EBITDA earnings.
In general, the higher the level of business risk revealed by your financial ratio analysis, the lower the business value, whether calculated on the company’s revenues, assets, or other financial variables.
You can uncover important trends in company’s financial performance by examining the ratios over time. Such trend analysis can help you demonstrate how the company has improved or fallen back within the period. Since business value is a forward looking concept, such trends help you identify significant business risks likely to impact what the business is worth.
If you need to support your selection of valuation multiples, compare your company’s financial ratios to its industry peers. If the company shows strength relative to others, then higher valuation multiples are reasonable. On the other hand, poor financial performance should guide you to choose lower valuation multiples.
Business appraisers usually pick two approaches when valuing a start-up: the income approach and market comparables valuation.
Income valuation challenge: earnings forecast
If you focus on the income approach, be aware of its limitations. Since the young companies have limited track record of earnings, it is challenging to forecast the income stream with any accuracy. Your business valuation is likely to suffer if your earnings forecast fails to match reality.
Market valuation challenge: few comparable companies
For start-ups in new technology driven industries, market comparisons are often limited or non-existent. By their very nature, tech start-ups are technology innovators and often blaze a path unseen by existing companies. Apples and oranges comparisons don’t work too well here.
Despite all these difficulties, start-ups need to be valued for a number of reasons: to grant and value stock options to employees, comply with the tax and financial reporting requirements, attract investment, in acquisition or IPO scenarios.
How to avoid the pitfalls?
Here are some points to bear in mind when valuing a start-up:
Be prepared for a conservative business valuation if you delegate the task to a professional appraiser. The number may surprise you even compared to valuations you got from prior investment rounds.
The reality is most start-ups don’t make it to the IPO. Many more are sold or acquired, or close their doors. Your business valuation will likely reflect this as a possible outcome.
Your start-up valuation is always made at a certain point in time. Just because the company was worth more in the past, does not mean its value has grown by a desired amount. Your appraiser may spot headwinds on the horizon or challenge your earnings or market share growth assumptions. The result may be a business value lower than you expected.
If your start-up goes public and its value jumps, don’t assume your private valuation of a year ago was wrong. Public companies with stock traded openly on the market are worth more than their private counterparts. The reason is stock liquidity, which attracts many more investors, and drives up the stock value.
As the company gains momentum, its earnings forecasts become more supportable. So your business appraisal is likely to be more accurate. This holds true for successful start-ups. If you are the proud founder of a successful start-up, congratulate yourself. Take a look around and note that many competitors of yesteryear have fallen by the wayside.
Successful and rapidly growing start-ups are likely to attract the attention of large public companies. This increases the appetite for ownership of these young firms, and drives up their valuation.
Business people, investors, and creditors pore over financial statements to make decisions. If you are a business owner, you look at the company’s financials to see how well it has done, and what investments are needed to achieve its goals in the future. Investors, of course, want to know if the value of their investment is growing. And creditors are interested to make sure their money is safe.
Notice that all these needs depend upon the future outlook for the company. Will the business generate enough income to pay its owners? Will the growth in business earnings justify the money invested? Will the company have enough funds to pay off its loans?
The central question is: where does all this money come from? Firstly, from business revenues. Revenues must be compared against the business operating expenses as well as the capital required to support its sales and expansion plans.
So how can a business meet its cash requirements? Here is the short list:
By generating cash flows from operations
By selling shares of its stock
By borrowing from creditors
By selling some of its assets
If you consider borrowing from a commercial lender, you will quickly discover that their view of business comes with a large dose of skepticism. Bankers expect the worst, so they try to protect their interest assuming the worst case scenario for the company. Should the business cash flow fall too low, how will the loan be repaid?
The typical answer is by selling some business assets. That’s why the lender is likely very interested in the value of business assets. Note that this is very different from the book value carried on company’s financial statements. The real question for the lender is this: should the company fail to come up with cash for loan repayment from its profits, what can certain business assets fetch on the market if offered for sale?
In other words, the lender is interested in the liquidation value of business assets. The book value of depreciated assets shown on the company’s books is not helpful here.
As the saying goes, if you are not selling your business assets, you are buying them. The market value of these assets is what your company owns. Find out what the assets are worth before asking a banker for a loan.
Capitalization of business earnings is very common. The idea is to use the expected economic benefit for a single time period, usually a net cash flow projected for a year right after the date of business appraisal. Going forward, the business cash flow is expected to change at a constant rate year over year.
If this constant earnings growth assumption is not realistic for your company, you should use the discounting technique in your valuation. In such situations, you project business earnings for a number of years and apply the discount rate to determine the business present value, or what is is worth today.
The advantage of discounting is that it lets you determine the value of a company whose earnings are not constant and do not change at a fixed rate over time.
Beyond a certain point in time, the accuracy of your forecast diminishes. A typical way to handle this lack of certainty is to assume that business earnings would change at a sustainable constant growth rate in perpetuity. Hence, the business value is the sum of the discounted earnings forecast and the capitalized residual value beyond the forecast horizon.
Unsurprisingly, the discount and capitalization rates are closely related:
Note that the discount and capitalization rates become equal if business earnings don’t grow.
Valuing businesses by direct capitalization is very popular because it is so simple. All you have to do is estimate the net cash flows for a single year, and then apply the capitalization rate to calculate the value. While the discounting is a more general way to value a business, it requires that you estimate a set of business earnings for a period of time, say 5 – 10 years into the future, and then use the discounting method to calculate your value result.
Your business valuation is as accurate as the assumptions you make. For example, if you decide to use capitalization, check if the business earnings are likely to change at essentially a constant rate going forward.
On the other hand, your earnings forecast will drive the accuracy of the discounted cash flow valuation. If the projection is not realistic, you can easily overestimate or underestimate the company’s true worth.
Risk and return go hand in hand when it comes to valuing a business. The ability of a company to attract and retain the needed capital is essential in order to continue. The cost of capital is thus an important input in your business valuation.
Beta, a key element of the capital asset pricing model, measures the so-called systematic risk of a given company. In plain English, a company’s beta indicates how well the company’s stock price correlates with the market ebbs and flows.
The market beta equals 1. Any business whose beta is also 1 has the same level of risk as the overall equities market. In other words, the stock price moves up and down exactly with the changes in the broad stock market.
A company seen as a riskier investment will have a higher beta, as its stock price will fluctuate more than the market at large. A safer company has a lower beta. The investors tend to hold on to its stock longer and don’t drop it at the first sign of market volatility.
As you can see from the CAPM model, the company’s risk is the sum of the risk free rate of return plus the risk premium, the latter being the product of the company’s beta and the equity risk premium. The equity risk premium is the extra return the investors demand over and above a risk-free return on investments such as the long term US Treasury coupon bonds.
For public companies, whose stock trades on the open market, estimating beta is straightforward. If the company is privately held, historic stock prices are not readily available, so using betas of similar small public companies as a proxy is common.
When a beta is calculated for a public company, the correlation is established relative to a well known measure of the stock market. Typical choices are major indices such as Standard and Poor 500, or Morningstar US Market. Such broad indicators are all very good at predicting the overall market behavior, so the choice is up to you.
The key takeaway is no business operates in a vacuum. So a big part of your risk assessment is to see just how sensitive the company’s value is to the overall market.
The questions of risk and return are at the foundation of business value. Think about it: if you are putting your hard earned money into an investment, you would like to see a handsome return. But there is no guarantee. In fact, depending on the investment, you could get the return you expect, get more or less, or even lose your entire investment. Happens every day.
What is at play here? In short, the investment risk, meaning that you may not see your return expectations realized in full measure or on time. So in addition to estimating the financial returns, your business investment considerations should include risk assessment.
If you take a closer look at public capital markets, where most investors play, you will notice that larger companies, involved in stable industry sectors, tend to produce lower returns. Lots of investors buy the shares of stock in these bellwether firms because they are seen as relatively more safe and predictable investments. On the other hand, smaller growing companies must generate higher returns for the investors to bother putting their money into these as yet unproven businesses.
Flight to quality in troubled times – risk free returns
If the clouds gather in the markets, investors tend to dump risky companies and run for cover. In dire times, this is usually government backed obligations, most notably US Treasury coupon bonds. Why? Because Uncle Sam never defaults on its obligations, and always pays interest as promised. You money is guaranteed to be safe.
So any business investment is about both the risk and return. The higher the risk of a company, the higher the return investors expect.
Discount and cap rates – measure of company’s risk
In business valuation, company risk is quantified in the form of two factors: discount rate and capitalization rate or cap rate for short. In the simplest form, business value is calculated as the ratio of its returns divided by the cap rate. If you want to be more precise, you can use the discounting formula to calculate the so-called present value of the business. It shows you how much all that money you expect to get from your investment over time is worth today. Thus you can figure out the value of a business, based on a stream of income to be received in the future.
Take a look at the Build-Up model of calculating the discount rate. It clearly captures the various parts of investment risk in one neat formula. You start with a risk free investment, such as the US Treasury bonds. Then add up additional risk components as you narrow down your investment options.
The takeaway is: every piece of investment action has a price and reward. If you do your homework investigating companies, you should be able to figure out how much risk you are willing to take to get the returns you want. This process is called business valuation.
Some businesses are able to secure long term contracts that ensure continued revenue streams far into the future. What is the effect of such contracts on business value?
The answer is twofold. First, the revenue that is contractually guaranteed reduces the business risk. You essentially have a very good idea of what the earnings from such a contract will be and when they will be received.
Second, the expected revenue steam implies that you can prepare ahead of time. You can estimate the needed business expenses such as staffing and materials, and product production schedules, reducing uncertainly and waste. Importantly, you can optimize business operations for profitability.
Stable earnings point to higher business value
Predictable, stable earnings are always a good thing for a company. This reflects on its business value captured by a number of business valuation methods. Look, for example, at the value factors used by the Multiple of Discretionary Earnings method. Stability of earnings is at the top of the value factor list.
If you use the Discounted Cash Flow method in your business valuation, the contractually guaranteed revenues would likely lead to a much more reliable cash flow forecast and reduced discount rate. The result you calculate is more realistic and likely denotes higher business value.
Cash cow businesses command higher market values
Companies with guaranteed earnings are known as cash cows. Investors and business buyers are eagerly looking for businesses like that all the time. So market demand for a company with long term customer contracts is very high. This drives up competition and increases the business market value.
In summary, business value is about risk and returns. Predictable earnings and low risk are great indicators of higher business value.
By established convention, companies are usually valued on the business enterprise value basis. For publicly traded companies, this is the sum of the shareholders’ equity, less cash or cash equivalents, and the total value of debt. This represents the current value of the company regardless of the capital structure, i.e. what types of debt or equity capital the firm uses.
Private companies often sell in an asset sale transaction. This generally includes the value of its long-term assets, also known as furniture, fixtures and equipment (FF&E for short) as well as the intangibles such as business goodwill. Typically, the accounts receivable are retained by the seller, along with the company’s cash assets. Inventory is often valued separately and can be added to the asset sale value. Again, the value of debt is added back to the equity value of the company. That’s because in an asset sale, the buyer expects the company assets to be delivered free and clear.
On occasion, a company can be sold on a stock basis. In this case, the buyer assumes the firm’s liabilities. The equity value of the business in this case excludes the liabilities but includes all short-term and long-term assets.
Given this diversity of business values, you should consider advising the readers of your business appraisal report what type of business value you have determined. It could make a major difference if the the person reading your report mistakenly assumes that your analysis concludes the business enterprise value when in fact you have calculated the equity value. If the firm uses debt capital for financing operations, this is likely to understate the actual value and result in misunderstanding down the road.
Even if you use the recognized terms for reporting business value, be sure to spell out what is actually included in your results. Indeed, the specific description of what is included in your business valuation calculations is required by all major business appraisal standards.
Business people are sold on the usefulness of financial statement projections for company financial management purposes. Pro forma financials are the staple of corporate financial analysis. In addition, these pro forma projections form the basis for credit analysis and estimation of how much debt or equity financing the firm will need in the future.
You can run ‘what-if’ scenarios to see what types of pressure the company will experience should some key financial and sales parameters change. This is an excellent way to reveal potential risks facing the business.
Business valuation is about assessing future returns and levels of risk for the company. So financial modeling is at the heart of business value analysis, especially when you use the valuation methods under the income approach, such as the discounted cash flow technique.
Most financial forecasting models are sales driven, in other words they assume that majority of balance sheet and income statement items are in some way related to sales. For example, accounts receivable are typically set as a percentage of sales. The fixed assets can be modeled as a function of the sales level they are intended to support.
In your financial forecasts, you should distinguish between the items that are functionally related to sales and those that are driven by policy decisions. For example, the asset levels are typically assumed to be functionally related to the sales. You need to have certain assets to generate sales, such as levels of inventory.
On the other hand, the proportions of long term debt and equity can be seen as a policy decision made by the firm’s management.
To make sure your financial forecast can be used in business valuation, you need to handle the so-called plug in your model. That is the balance sheet item that is needed to make the model work. It meets the following financial statement requirements:
Making sure the balance sheet, i.e. assets and liabilities, are ‘in balance’
Ensuring the model correctly represents the company’s planned investments
Usually, the model plug will take one of these forms:
Cash and cash equivalents
Let’s say you choose cash and cash equivalents as the model’s plug. Mathematically, the balance sheet is in balance if the cash and cash equivalents plug equals the difference between the firm’s total liabilities and equity and its other current and fixed assets.
In the financial sense, this approach states that the company will not sell its stock, repay or raise additional debt. Instead, the business is expected to be financed by its own cash. This, of course, assumes that the company has enough cash on hand to fund its operations.
You can value the entire business and calculate its value which includes all of its assets. This brings up a question, do individual business assets have value on their own? The answer depends upon the reason for valuation.
Consider, as an example, a piece of machinery the business uses to produce its products. Chances are the machine can be sold to an equipment dealer for a certain sum. Thus, this asset has a market value and can be taken out of the production line to be sold.
This example points out two critical elements associated with asset values:
Note that the machine in our example above was both separable and marketable, thus its value could be easily determined. All you have to do is make a couple of calls to used equipment dealers to get an estimate of the fair market value.
Now let’s consider a rental agreement the company has signed, locking in attractive rental rates for a period of time. This is a valuable intangible asset as it puts a cap on an important business expense going forward. Is it valuable?
Asset business value depends on who values it
The answer is it depends on who is doing the valuation. For the current business owners, the rental agreement is definitely valuable. In fact, its value is determined by the amount of relief the company gets from paying higher rentals in the future.
On the other hand, the rental agreement may be non-transferable. So if the company came up for sale, the new owners would have to renegotiate the rental agreement and the new terms may not be nearly as attractive. If the business buyer values the company, the value of this non-transferable rental contract is zero.
This distinction is often missed by business people and financial advisers: for whom is the business value determined?
Once you answer this key question, you can address the elements of separability and marketability to figure out if the asset is worth anything on its own. A good example of non-separable business asset is trained and assembled workforce. If the company is sold, the expectation is the employees, at least some of them, will remain with the business. You can’t sell employment agreements on their own, so the workforce asset is not separable or marketable, at least not in a free market economy.
If the company owns an asset that can’t be transferred to another party, its market value can’t be established. Just like in the above example with the business premises rental, the value is limited to the current business ownership.
That being said, many business assets can be very valuable, i.e. they can be pulled out of the existing business operations and sold to someone else. Obvious examples are equipment and machinery. Other examples include intangible assets such as patents and trademarks.
You can value the patents by using the so called relief from royalty method. Basically, you estimate the typical royalty payments the company would have to make in order to license a comparable invention from an outside patent holder. The present value of the royalty payments needed would give you a fair estimate of what the patent is worth.
Asset replacement is another way to look at a business asset value. What would it cost the company to develop and put into use similar set of assets? Consider the costs and time needed to re-develop in-house software tools, or a set of procedures used to produce company’s products. You can discount these costs to the present time to estimate the value of such assets.
The takeaway on business asset valuation is this: while the entire company is usually assumed to be marketable and valuable on its own, the individual business assets may lack in one or both of these key value factors. When in doubt, always consider if the business assets have a real secondary market and can be offered for sale on their own. In addition, always ask for whom the value is determined.