Archive for November, 2010

There is one important attribute all early stage companies have in common: limited earnings track record. Young companies are usually busy trying to figure out the best ways to coordinate their key resources – labor, capital, and entrepreneurial skill to come up with a winning business model.

If you need to value a young company, these considerations should play a key role in your business valuation method selections. You can value any business using one or more of the three key approaches:

  • Asset
  • Income
  • Market

Asset based business valuation for growing firms

As we mentioned above, the early stage companies spend a lot of time optimizing the use of their asset base. They may also be involved in heavy development of key intangible assets such as technology, vendor and customer contracts, and intellectual property.

One important intangible asset you may be aware of is business goodwill. Yet goodwill takes time to build and is typically a large portion of an established firm’s value, not a young start-up.

Hence, the valuation methods under the asset approach are unlikely to help you establish the true economic value of a young growing company.

Market approach and young company appraisal

Market-based valuation methods let you develop business value based on comparison to recent sales of similar businesses. Bear in mind though that the vast majority of private business ownership transfers involve established firms.

Many of the valuation multiples used under the market approach depend on various earnings bases to do the comparison. The typical examples are the company’s EBIT, EBITDA, discretionary cash flow, net income and net cash flow.

There are a number of challenges you may face when using the market valuation methods. A young company may not yet be optimized for profitability. In addition, comparison to well-established firm values makes little sense. Hence, the market-based valuation methods are not the best choice for early stage company valuation either.

Income-based valuation for early stage companies

This leaves us with the methods under the income approach to business valuation. These methods help you determine the value of a business based on the expectation of earnings and risk going forward. This is a good match since young companies have yet to demonstrate their true economic potential and generate an income stream at a risk level acceptable to the owners.

Perhaps the best business valuation method you can pick is the Discounted Cash Flow technique. This powerful method lets you calculate business value directly based on your earnings forecast and risk assessment which is captured by the discount rate.

Given a degree of uncertainty in realizing the future earnings, you may consider running a number of valuation scenarios. The typical format is to repeat the Discounted Cash Flow valuation under the base case, worst case, and best case assumptions. You can then conclude what the company is worth today based on a weighted average of your results. The weights should represent the likelihood of each scenario.

Valuing a Business based on Cash Flow

One of the most useful business valuation methods under the income approach is the Multiple of Discretionary Earnings technique. Formally known as a direct capitalization valuation method, the Multiple of Discretionary Earnings lets you determine business value based on two key elements:

  • Company’s discretionary earnings
  • A set of financial and operational value factors

As with any capitalization method, the Multiple of Discretionary Earnings applies a cap rate to the business earnings to come up with a business value number. The difference is how this capitalization rate is calculated.

The approach taken by this method is to build up the cap rate based on your assessment of the business risk factors. Each factor affects your business valuation result to a different degree. Together, this business risk evaluation offers a very comprehensive yet intuitive framework for business valuation.

Here are the business valuation factors, along with a brief description of each:

Business earnings track record

Companies that generate stable, above industry average earnings are more valuable. The higher this valuation factor, the lower the risk that business earnings can decline unexpectedly. The net effect is a greater business value.

Industry growth prospects

Firms operating in rapidly growing industry sectors are more valuable. These days companies in the health services, energy and education are likely to face favorable growth prospects because the demand for these types of products and services is growing.

Business growth prospects

Regardless of the industry your firm operates in, business value depends largely on the company’s earnings growth outlook. This valuation factor is highest for the companies with an outstanding earnings growth track record.

Ease of access to business financing

Financial capital is the lifeblood of successful businesses. Ability to attract and retain required financial resources is key to business success – and directly impacts what the company is worth.

Competitive environment

Businesses that compete in the market segment dominated by a few large, well-funded competitors face tough times ahead. Your company is likely to be more valuable if it does most of its business in highly fragmented market sectors with many smaller competitors.

Location

Location can make or break a business. Great customer access, well-designed premises that invite both new and repeat business tend to go with higher business values.

Customer concentration

Most successful companies try to reduce dependence on a few large customers. Should any one customer be lost, the effect on business earnings is minimal. The more loyal customers a company has, the higher its value.

Product and service concentration

A diverse product and service mix is the hallmark of successful business. This helps companies overcome seasonal variations in demand as well as establish themselves as a one stop shop for many customers.

Market concentration

Much of business success and growth outlook depends on how well it can enter a number of markets. For example, firms with a regional presence are more valuable than local companies. This market diversification reduces business risk and adds to business value.

Business competitive advantages

Sustained competitive advantages such as great technology, exclusive distribution rights or highly loyal customer following are sure value creators for any business.

Business marketability

A business is more valuable if there is considerable demand for similar companies by business buyers.

Ease of operation

A turnkey operation is easier to acquire and, therefore, attracts more potential business buyers and investors. Given the increased demand, the company’s market value is likely to be higher.

Skill and knowledge of staff

Great companies succeed by attracting, training and retaining great people. Such workforce is one of the most valuable business assets.

Quality of the management team

Savvy business decisions that help the company grow are no accident. An experienced management team can steer the business through good times and bad and greatly increase its value.

Example: Business valuation as multiple of its earnings

This valuation method is both intuitive and powerful. Why? It lets you score a business across the key value drivers and come up with a rock solid business valuation result.