If you are valuing a company that is going through a period of rapid growth, the Discounted Cash Flow business valuation method should be high on your list of choices. Using this key income-based business valuation method, you can get very accurate results. This is because the discounted cash flow business valuation lets you capture the company’s growth rate and associated business risk directly.
Discounted cash flow method calls for three types of inputs:
- A stream of projected business earnings, such as your business net cash flow, usually on an annual basis.
- Discount rate representing the business risk.
- Long-term business value, often called its terminal value.
Business terminal value estimation
If you take a look at the terminal value formula, you may notice that the denominator is the difference between the discount rate and the long-term growth rate in business cash flows. This is the so-called capitalization rate or cap rate for short.
Handling negative terminal values
For some high-growth companies, the terminal value can become negative. This happens if the business cash flow growth rate exceeds the discount rate. So how do you handle such situations?
In such cases, you can estimate the terminal value as the expected gain from a future business sale. Here is one way to this:
Step 1. Project your business revenue or discretionary cash flow several years into the future. Take the values from the final year of your projections. For example, if you do projections for 5 years, use the numbers from year 5.
Step 2. Use the market-based valuation, such as ValuAdder Market Comps to estimate the current value of the business, based on the projected revenue or cash flow from Step 1.
Step 3. Factor in the effects of inflation by indexing the business value from Step 2. You can use the ValuAdder Future Value calculation to do so.
Step 4. Subtract the expected business sale transaction costs from the business future fair market value determined in Step 3.
Step 5. Use the value from Step 4 as the long-term terminal value input in your Discounted Cash Flow business valuation.
If you expect that your business valuation results will be reviewed by tax authorities, you may need to prepare a business appraisal report that meets several key requirements.
In the US, for example, the Internal Revenue Service has published the Revenue Ruling 59-60 in 1960. This central publication outlines a number of requirements that a business appraisal report must meet in tax related situations:
- The report must provide a complete description of the business operation history.
- You need to include review of the economic conditions that affect your business and its industry.
- There should be a discussion of the company’s financial condition, indicating the book value of its shares.
- The business appraisal report must offer a solid analysis of the business earning capacity.
- In some cases, you may need to review the ability of the business to pay dividends.
- The presence and value of business goodwill needs to be determined.
- If the company offers its stock for sale, the size of the block being valued needs to be specified.
- Market prices of actively trading stocks of businesses in your industry.
Most small businesses do not pay dividends. If this is your case, your business valuation report needs to include well prepared business earnings forecast. In addition to satisfying the tax authority requirements, such cash flow projections are essential for accurate business valuation under the income approach.
Ask any seasoned business appraiser and you will hear: there are three ways or approaches to measure the value of any business, large or small.
True, but there are some big differences between a small privately owned business and a multi-national giant. To get an accurate small business valuation you need to keep a few key points in mind:
Small business market value comparisons are harder
There is plenty of reliable market evidence to figure out the price of a public company stock or bond. Knowing the price per share and the pool of outstanding shares gives you a pretty good idea of a public company’s market cap.
The pricing multiples are also pretty consistent since public companies are required to follow well-defined financial reporting rules. This being the case, you can generally use a number of pricing multiples to estimate the company value. Examples are price to earnings, price to gross revenue, gross profit, book value of assets and many others.
In contrast, there are no reporting requirements for sales of private company ownership interests. Private businesses may also report their financials differently. Hence, you need to use care when applying pricing multiples.
To make an “apples to apples” business market value comparison, you need to carefully recast the financial statements of a small business. In small business valuation you will see the business revenue, seller’s discretionary cash flow or net cash flow as the common bases for your pricing comparisons.
Availability of reliable transaction data in some industries may be a problem too. In such cases you may need to study business sales in a broader industry group to gain an understanding of how the market place prices similar businesses.
Small business value drivers are different
Values of publicly traded companies are pretty much defined by what the investors think of the company’s financial performance and future prospects.
The value of a small business may be seen quite differently. For many small business owners, lifestyle considerations, such as buying a job or pursuing a lifetime goal are major factors which affect what a small business is worth.
One key reason for this different perception of business value is this: small business owners typically work, and often live, in their businesses. Public company investors generally do not work in the firms they invest in.
The well-known Multiple of Discretionary Earnings business valuation method is a very good fit for valuing owner-operator managed small businesses. The method lets you account for a number of important factors in your business valuation.
Small business ownership interests are less marketable
Small businesses are almost always privately owned. You can bet that private firm ownership interests are considerably harder to sell than their publicly traded counterparts. It takes just seconds these days to unload public company stock.
It may take months or even years to sell a privately owned company. Needless to say, there is uncertainty as to the price you get for a closely held business. Investors view private business ownership interests as higher risk illiquid investments and apply marketability discounts to their value.
Most small business valuations are done on a controlling interest basis
Public company interests are typically valued on a minority ownership basis because most sales are done by investors holding a small number of company shares. On rare occasions when a controlling interest in a public company is being acquired, you will often see a much higher price per share. This is known as the controlling interest premium which can easily range in the 40% – 80% range over the stock’s market price.
When small businesses sell, it is almost always the case that the entire company or its assets change hands. Hence, small business valuation is typically done on a controlling ownership interest basis.
Fair market value standard is typical in small business valuations
Fair market value is the most common standard of business value applied when valuing small businesses and professional practices.
There are many more small businesses than large ones. Hence, businesses with comparable earning power compete in the market place, which tends to establish the selling price consistent with the business fair market value.
In contrast, valuation of publicly traded companies is frequently done on the so-called investment standard of value. This is especially true when a company acquisition is planned in order to meet strategic business objectives of the acquiror. Choices may be quite limited here. Business values and, consequently, prices paid for such acquisition targets can reach very lofty levels indeed.
Accuracy of small business valuation requires that you match your earnings basis and cap/discount rates
Income-based business valuation methods require that you estimate the so-called discount and capitalization rates. These rates are determined using a number of cost of capital models. All these models rely on the data you get from the public capital markets.
One very common mistake in small business valuation is applying the discount and capitalization rate to the wrong earnings basis. If you use the famous Discounted Cash Flow method for your business valuation, you can get very good results by building up your discount rate and using the net cash flow as your earnings basis.
Each business is unique in the way it creates value. When you need to measure what your business is worth, it is good practice to choose a number of proven business valuation methods.
For example, you may select a method under each of the major business valuation approaches: Income, Market, and Asset. This way, you can ensure that your business valuation results are on a solid foundation.
ValuAdder is designed as a flexible toolkit that makes your business valuations quick, accurate and comprehensive. You can pick the business valuation methods with a mouse click and create valuation scenarios that best match your needs.
And you can do all your business valuation calculations in any currency. ValuAdder automatically adapts to your computer settings and displays the currency that fits your location. You can change the currency at any time. For example, on a Windows computer do the following:
- Click on the Start menu in the lower left corner of your display.
- Click on Control Panel and select Regional and Language Options.
- Now choose your regional format, such as English (United States).
Start ValuAdder to do your business valuation calculations in your regional currency and number format. What’s more, your business valuation reports also use the currency of your choice.
Retail industry is very large and its well-being is essential to the health of the overall economy. As an example, the retail market segment represented by the US department stores, SIC 5311 and NAICS 452111, has over 3,500 establishments generating just under 76.9 billion dollars in annual revenues and employing more than 534,000 people.
Retail businesses come in all types and sizes – from a neighborhood specialty shop to large “formula store” chains owned by major multi-nationals.
Major trends that affect retail business value
A number of important trends are clearly visible on the retail landscape:
- Proliferation of “big box” retail chains.
- Growth of franchise systems.
- Emergence of the Internet as a viable way to reach many retail customers.
The continued advance of large chains has posed serious problems for many small retailers. Many successful stores now focus on niche markets that can be served profitably with a highly targeted product mix backed by excellent customer service – something that small businesses can do very well.
At the same time, franchise systems offer smaller retail operators a “safety in numbers” approach to competing against the large chains. Proven marketing strategies, product selection and good store management systems work to level the playing field.
Internet has come of age as a viable commerce channel. In addition to the “pure play” online businesses, many traditional retailers now have a presence on the Web, effectively becoming the multi-channel “click and mortar” operations.
Retail business value drivers
Here are a few factors that affect the earning power and value of retail businesses:
- Inventory is the largest investment. Efficient inventory management is a key differentiator for successful retailers.
- Accounts receivable if the business offers credit.
- Relatively high employee turnover. Pay rates are lower than in manufacturing industry.
- Very strong location dependence.
- Shift toward focus on niche markets as a way to combat “big box” competition.
- Addition of services to gain pricing flexibility: “value-added” pricing advantage.
There is increasing use of modern POS (point of sale) and inventory management computer systems. These systems give small retail operators state-of-the-art ways to control costs, improve profitability and cash flow.
Effective inventory management reduces the working capital requirements, increases available cash flow and leads to higher business values.
Key success differentiators that add up to higher retail business valuations
1. Product mix and price. The retailer’s skill in developing a compelling product mix that is priced just right for the target market is key to creating repeat customers and traffic growth through referrals. And business growth prospects directly affect how much the business is worth.
2. Convenience such as store hours and location are critical to generating the foot traffic and developing customer loyalty. Repeat business tends to lower the marketing costs and smooth out the bumps in the business earnings – important business value enhancing factors.
3. Customer service. Nothing is more important to growing a solid repeat customer base than excellent service. Many small retailers realize this and make their stores into true destinations for the regulars. Superior customer retention tends to translate into lower operating costs and higher profit margins – and higher business value.
4. Store layout. Attractive, well organized store helps the customers stay longer and spend more money. Efficient use of the shop floor space results in higher revenue per square foot. Since valuation multiples based on store revenues are very common in valuing retail businesses, higher revenues tend to go with higher business values.
Key points to consider when valuing your retail business
1. Carefully recast your historic financial statements. Your goal is to demonstrate the true earning power of the business. Retail businesses are appraised based on cash flow, using seller’s discretionary cash flow or net cash flow as the earnings basis. Business cash flows can be very different from its profits!
2. Prepare an earnings forecast. As many a seasoned business broker will tell you, business buyers pay for the past, but buy the future. Not surprisingly, the business earnings prospects are more important when determining the business value, than its past financial performance.
3. Review the business asset base. Your cost-basis balance sheet may show asset values very different from their current fair market value. If you value a retail business using an asset-based business valuation method, you need to reconstruct the company’s balance sheet accordingly. Pay special attention to the values of inventory and furniture, fixtures and equipment.
Retail business valuation methods
As with any industry, you have quite a number of methods to choose from. A good practice is to use several methods under the standard Market, Income and Asset business valuation approaches. Here are a few suggestions that are very often used to value retail businesses:
Given the retail industry size, it is not surprising that a number of closely held retail businesses change hands regularly. You can use the sales data to compare your business to similar businesses that sold recently. Such sales data is typically used to derive the so-called pricing multiples.
The pricing multiples are ratios which relate the business selling price to its revenue, net sales, cash flow, net profit or EBITDA, and business assets. Using such multiples, you can estimate your business likely selling price, using your business financial parameters.
Multiple of Discretionary Earnings
This income-based business valuation method is a very good fit for valuing owner-operator managed retail shops. In addition to accounting for the business earnings and industry growth, this method lets you factor in such important business parameters as location, competitive environment, ease of operation, quality of the staff and overall desirabilty.
Capitalized Excess Earnings
Asset-rich retail businesses are frequently valued using this classical business valuation method. The method seeks to establish the business value as the sum:
Business value = net tangible assets + business goodwill
If you are looking to value an established business which has become a true “institution” in its market, Capitalized Excess Earnings is an excellent way to show the value of business goodwill.