# Archive for February, 2012

## Drawing the business value conclusion

Given all the various business valuation approaches and methods, you have quite a choice of tools to calculate business value. However, each valuation method you use produces a result that may differ from others. When it comes time to state the subject business value, how can you reconcile the differences?

There are a couple of choices. Traditionally, the final result of a professionally prepared business valuation is stated in the section of an appraisal report entitled Business Value Conclusion.

In this section the appraiser would list the results obtained from the selected business valuation methods. Then a weight would be assigned to each result depending upon the relative importance and relevance of the method to the appraisal at hand.

Finally, the business appraiser would calculate the weighted average of all the results to come up with a single number. For example, let’s say that our business valuation used the following methods:

Valuation Method Result Weight
Capitalized Excess Earnings \$2,500,000 40%
Discounted Cash Flow \$2,750,000 60%

If you apply the indicated weights to the results above, the weighted average business value works out to be \$2,650,000.

Of course, you would mention in your report why you have selected the weights. Perhaps the company is expected to undergo rapid growth in the near future. You have reflected this upside in your cash flow forecast and used this key bit of information to value the business using the discounted cash flow method.

This puts the spotlight on a very important part of your analysis and justifies a heavier weight on your discounted cash flow valuation.

### A range of possible business values

An alternative way to report your business valuation results is a range of values. In the example above you can state that the business is likely to be worth somewhere in the \$2,500,000 to \$2,750,000 range.

The wiggle room is actually a way of saying that there is market uncertainty that may affect the actual business value putting it somewhere in the middle of your range estimate.

Why can valuation methods produce different results when valuing the same business? Because each method is based on a different economic foundation and uses a different computational procedure. Take a look at some of the best known valuation methods to see this:

## Business valuation and earnings basis

Whatever methods you choose for your business valuation, proper selection of the inputs is critical to the accuracy of your results. This is especially important if you are working with the income-based valuation methods such as the Discounted Cash Flow.

Business valuation is about the economic value of the company. So accounting measures of income such as revenue, net income or gross profit are generally not suitable for business valuation directly.

Instead, the discounted cash flow method requires a cash flow based earnings basis that truly captures the economic benefits the owners can derive from the business.

The typical earnings basis used in professional business appraisals is net cash flow. Note that, by definition: it is the measure of earnings that you can extract from the business without adverse effects on its operations.

### Net cash flow – removing the capital structure from the equation

Here is how you can calculate the net cash flow of a company:

• Add depreciation and amortization expense
• Subtract changes in working capital
• Subtract capital expenditures

Note the conspicuous absence of the debt principal repayments or long-term debt increases. In fact, you may notice that the effect of capital structure is completely factored out of the net cash flow. In other words, we determine the cash flow to total invested capital, both equity and debt.

Financing activities such as offering company stock for sale to outsiders or repurchasing stock are usually not a large source of cash flow for private companies. Venture-backed startup businesses do offer their stock to investors. However, the cash proceeds are typically plowed back into the capital expenditures and increased operating expenses to help grow the company. Hence, the immediate effect on the net cash flow is essentially zero.

### Business value to total invested capital

This makes sense if you consider business valuation on the typical business enterprise basis. The idea is to determine the total value of the company regardless of how its assets are financed.

Business owners have complete discretion about how to finance the company. Should the business be acquired or merge with another firm, the ownership may well decide to change the capital structure by reducing the leverage, renegotiating loan terms or injecting additional equity capital.

Bear in mind that such policy decisions can bring about positive changes in the long term. However, they do not have an instantaneous effect on business value.