If you are considering using the income based methods in your business valuation, you have two main choices: capitalization or discounting. In simple terms, the difference boils down to how you intend to treat the expected changes in business earnings going forward.
In using the discounted cash flow method, you specify the anticipated earnings explicitly in the calculation. On the other hand, the capitalization valuation implies that the business earnings will change at a constant rate in the future. This assumption is rarely met in the real world.
Capitalization also misses the timing of earnings changes. If your target company is likely to experience a rapid growth in earnings, especially early on, it’s best to use the discounting technique to capture it in your valuation.
On a general note, consider some situations that favor one choice of the valuation method over the other:
Steady, evenly growing earnings
If the rate at which the business earnings change is nearly constant then the capitalization of earnings is appropriate for valuation. The accuracy of your results likely would not improve if you used the more complex discounted cash flow technique.
Uneven change in business earnings expected
If you can generate a reliable earnings forecast with significant swings in the cash flow over the years, discounting will produce a more accurate result.
Significant change in earnings, uncertain timing
If your company’s cash flow is expected to change widely and timing of these changes is hard to predict, business risk is increased. The result is a higher discount rate. But since your earnings forecast is less reliable, the capitalization method is just as accurate in this situation.
Rapid business earnings growth over a short period
If your target company is experiencing a growth spurt that you can clearly forecast, use the discounted cash flow method. Once the company’s earnings settle into a more sustainable growth mode, you can make the assumption of constant growth rate in perpetuity. This is a perfect scenario for using the discounted cash flow valuation.
If you ask a business appraiser, you will hear: business value is in the eyes of the beholder. In formal jargon, business valuation results depend on the standard of value you use.
One of these standards is known as the intrinsic value. As the name implies, this is the measure of value one figures out by focusing on the fundamental characteristics that create value in a company. Note that this is very different than the fair market value that is often used by business people when comparing a company to other firms.
Intrinsic value is the price of business ownership that is determined by a valuation analyst following an in-depth or fundamental review of the company’s earning power, assets, and other value drivers.
In layman’s terms, the company’s intrinsic value is its true or real value, something that is revealed after careful consideration of all the value creating factors. An analyst setting out to figure out the company’s real worth will study its products, customer base, competitive position, relationships with suppliers, capital resources, management, skilled staff, among others.
When fair market value and intrinsic value converge
What happens if many serious investors do this analysis and arrive at pretty much the same value number? Now the intrinsic value becomes the company’s market value as these leading investors cast their votes by buying or selling company’s stock at a certain price.
Business valuation – foundation of sound investment
Figuring out intrinsic value for any business is no easy task. It is named fundamental analysis for a reason. If you really want to know what a company is worth, you roll up your sleeves and delve into a rigorous study of all the important elements that create or destroy value in the firm. Your investment decision is then guided by your conclusions: is the company’s stock priced higher, lower or in line with your findings?
Weeding out the hype
This lets you weed out market hype and inflated prices and zero in on value priced companies worth your while. The serious investor is rewarded with insight into promising companies before the market sentiment catches up. You get to hit pay dirt before the gold rush sets in.
Note that the legal definition of intrinsic value may differ from the economic concept. When in doubt and facing a legal challenge, check with your attorney on how the case law or local statutes see it.
Take a look at a professional business appraisal report and you will see the valuation date prominently displayed. Clearly, business appraisers deem this date worthy of mention. Why is this the case?
Business value changes over time
Business value can change quite a bit depending on circumstances that change over time. If you pay attention to the public stock market you will spot the ups and downs in prices as investors become aware of new company information and fluctuations in the economy.
An abrupt drop in company’s profits is a cause for concern and can depress its value significantly. If businesses can’t get required capital on attractive terms, their ability to invest for the future could be impaired. The result is often lower earnings and a drop in business value. A major customer departure could put a kink in a company’s sales and knock its value down.
Beware of valuation multiples that are out of date
If your valuation uses the market approach, comparison to similar companies should be done in a timely manner. Market comps depend critically on your ability to assess the current values of similar companies relative to their revenues, profits, asset bases or equity. As the market sentiment changes, so do the relationships between business financial performance and its value. Stale valuation multiples are one reason business valuations go south.
Business valuation repeated at different times
To make things even more interesting, your business valuation may be done as of several dates. This is common in divorce cases when the parties seek to establish how much business value has changed over the course of marriage of the business owners.
In the unhappy scenario of having to do a business appraisal for litigation, the court may determine what dates you should use. Before taking on the job, consider carefully whether you can do business valuation as of the dates the court wants. You may have little choice but to comply and your ability to complete the valuation engagement could prove critical to your client’s success.
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.