Perhaps the greatest advantage of the renowned Discounted Cash Flow business valuation method is its flexibility. You can choose any stream of business income and discount it to determine the business value today. However, to get accurate business valuation results, you need to match your earnings and the discount rate carefully.
Net cash flow and build-up discount rate formula
Most business appraisal experts recommend the net cash flow as the earnings basis for use with the Discounted Cash Flow method. The widely accepted rationale is this:
The discount rate, which captures your business risk, is typically derived from the public capital markets. The investors in these markets generally obtain the economic benefits equivalent to the net cash flow. Hence, the use of net cash flow to ensure that the earnings basis and discount rate are matched.
That said, you can make an adjustment to the discount rate and then use it to discount a different income stream, such as the seller’s discretionary earnings.
In this case the discount rate will need to account for the additional opportunity cost of owning and operating the business. This cost is not included in the Build-Up cost of capital formula directly – since typical investors do not work in their portfolio businesses.
Once matched, the two sets of income streams and discount rates should provide you with comparable results.
Discretionary earnings and capitalization rate that match well
In comparison, the Multiple of Discretionary Earnings, a widely used direct-capitalization method, uses the seller’s discretionary cash flow as the earnings basis. The capitalization rate is developed from the 14 business financial and operational factors you specify.
This cap rate is matched specifically to the seller’s discretionary cash flow as the earnings basis. An important difference from the net cash flow is that SDCF includes the single owner-operator compensation and non-recurring business expenses as addbacks.
Companies large and small often realize that they cannot be all things to all people. A business may excel at product development but have little experience in providing specialized services to its customers. A company may have an established position in a regional market place, but lack resources to enter a larger national or international markets.
In such cases, business owners can decide to form a joint venture with another firm that has the capabilities they lack in their own organization.
Joining forces together has advantages in that each partner in the venture brings the right and complementary set of skills and abilities to the table. Given the synergies that may result, such combination can do very well indeed.
Whenever a joint venture is considered, a couple of important questions arise:
- What is the overall business value of such an enterprise?
- How is the business ownership allocated among the venture partners?
Most of the time these business valuation issues arise in the planning phase, before the business combination is finalized. Hence, there is no track record of the joint venture’s financial performance. Under these circumstances the income approach to valuing the business is the best choice.
Business valuation of a joint venture – methods
Using the income-based business valuation methods makes sense because they let you determine the value of the joint venture directly from your financial forecasts and risk assessment.
Assuming that your venture partners buy into the financial projections, you can determine the business value of the entire enterprise by using such well known valuation methods as Discounted Cash Flow.
Valuing a Business based on Cash Flow and Risk
This agreement on the expected financial performance of the joint venture is essential to determine what the entire business is worth – and address the first question above.
Determining the value of business ownership interest in a joint venture
Allocation of the business ownership interest depends upon the relative contribution each partner makes to the joint venture.
Let’s say that the combined company will design and market a new product. One of the partners has the research and development expertise while the other has experience in marketing, sales and distribution of similar products. Each brings considerable value to the venture. What are their interests in this business worth?
Assume that your financial projections were used to calculate the total business value of the venture to be $10,000,000. The partner will provide the product and technology for the venture. The value of such business contribution can be estimated using the asset approach to valuing businesses. Your goal here is to estimate the costs of creating a suitable alternative.
If you were to develop the product by yourself from scratch, the costs associated with this effort can be estimated. In addition, there is an opportunity cost incurred due to sales lost while the product is being developed. Let’s say that you estimate these costs to be $4,500,000.
This provides the estimate of your partner’s share of the venture, which in this case equals 45% of the total business value. If no adjustments are made, you would wind up with 55% of the company which gives you the controlling ownership interest in the venture.
If your partner insists on having an equal stake in the joint enterprise, a balancing payment of $1,000,000 would need to be made.
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With ValuAdder 4.0 we follow this tradition to give business people anywhere the valuation software system that has stood the test of time:
- Market-derived valuation rules of thumb for over 400 industries. Virtually all business types are now covered!
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- Worksheets streamlined for quick financial statement recasting and forecasts – an important requirement for any business valuation.
- Flexible selection of any business valuation method under the standard income, market and asset approaches. You can do what-if scenarios, side-by-side comparisons and custom business valuation method selections with a mouse click.
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The result? Quite simply, the business valuation system that is more accurate, flexible, secure, easy to use and reliable than anything available on the market.
Business market value comps for over 400 industries
For market comps, we have focused on additions in the hottest industries of today. The industry coverage in the ValuAdder Rules of Thumb module is now the impressive 402! You can estimate your business fair market value in just about any industry – by direct comparison to similar business sales.
Here are the latest additions:
Health care services
- Intermediate care facility
- Nursing and personal healthcare services
- Specialty hospitals
- A number of medical laboratory and test facilities
Energy sector and green industry businesses
- Energy management and conservation services
- Oil and gas production, development and exploration
- Oil and gas well drilling services
- Recycled wood products manufacturing
- Recycled paper products manufacturer
- Metal products recycling
- Metal distributors and service centers
Personal and business finance, insurance
- Personal and consumer credit companies
- Short term business credit, factoring services
- Business credit and underwriting services
- Life insurance carriers
- Accident and health insurance
- Hospital and medical service insurance plans
- Fire, marine and casualty insurance
Information technology services
- Computer facilities management service
- Computer maintenance and repair
- Computer peripherals and software products value-added resellers
- Electronic components manufacturing.
- Radio, television and electronics store.
- Private schools, including pre-school, elementary and secondary education levels
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- Junior / associate degree colleges
There are also extensive updates for the restaurant, construction, finance and real estate industries.
Construction companies are frequent business acquisition targets. The volume of business sales is largely due to the industry size – there are over 346,000 firms in the single-family housing construction alone, classified under SIC 1521 and NAICS 235510.
While this construction industry segment generates over $196 billion in annual sales, the average construction company is small – employing just 3 people and generating around $600,000 in annual revenues.
There is a sizable pool of business buyers looking for construction companies, especially in the mid-market segment – with the profitable firms topping $5,000,000 in gross revenues.
If you own a business in this industry or plan to buy one, knowing the value of your construction company is essential. While standard business valuation methods under the income, market and asset approaches work well for construction business valuation, there are 5 key factors you need to keep in mind:
Construction company worth: 5 key factors
- Longevity, name and reputation of the business make a big difference to what the company is worth.
- Value of a construction company is affected by the expected level of repeat business. Established sales and marketing function that does not depend on the current ownership translates to higher business value.
- Current contract pipeline and billing practices.
- Accounts receivable collection. Slow collection calls for higher working capital which increases business risk and leads to lower valuation multiples.
- Availability and retention of key skilled employees.
Often, higher business selling prices are achieved when a company sells to a competitor or a larger firm looking to enter the market.
Construction business valuation methods
Since construction firms sell often, there is plenty of market comps to determine the construction company worth. Market-derived Valuation Multiples for construction companies under the SIC 15, 16 and 17 are generally based on the business discretionary cash flow or EBITDA.
For owner-operator managed businesses, the Multiple of Discretionary Earnings business valuation method is an outstanding choice. In addition to the business earnings, this method lets you account for the 5 factors above when valuing a construction company.
Well-established construction businesses may have considerable goodwill. Consider using the time-tested Capitalized Excess Earnings method to measure the worth of your construction company, as a sum of its tangible assets and business goodwill.