The discounted cash flow (DCF) method is ubiquitous in valuation of businesses and business assets. The net present value analysis is the extension of the standard DCF technique in valuing capital investment projects. Such projects cover business valuation in acquisition scenarios as well as purchases of equipment and machinery.
Yet with all the popularity of DCF analysis, the methodology does have a weakness: it does not account for the flexibility in capital investment projects. If you were ever involved in a large scale capital investment projection, you might have noticed that the company can change its decision in real time depending on the situation.
Just some examples that often happen in the real world:
You may be considering upgrading some equipment across the entire company. Before committing to such a major outlay though, you might want to replace one or two machines first and see how well they perform. If the performance meets your expectations, you could choose to proceed with the enterprise-wide upgrade. If the early results prove disappointing, you might reconsider your replacement plan.
From the investment perspective, this works like a call option. You reserve the right, under no obligation, to buy some assets on or before a future date at a predetermined price.
Here is a different example. Your company is considering a project that could result in some future cash flows. There is a degree of uncertainty as to whether this income expectation will pan out. If you use the discounted cash flow valuation, your analysis is going to miss this downside. To deal with the uncertainty, you could opt to drop the project early if things don’t look as expected.
This strategy works like a put option. You reserve the right to abandon the project. You contract the scale of the project investment early should things not work out.
In capital investment valuation, these strategies are known as real options. They work to extend the power of the discounted cash flow valuation. In a sense, your project becomes more valuable because you allow for more positive outcomes. The discounted cash flow analysis assumes that you are committed to investment without regard for the options of bailing out early it things don’t work out.
If real options are part of your business strategy, your DCF analysis could underestimate the value of the project.
If you are like most business people, figuring out the value of a public company seems straightforward. There is plenty of up to the minute information on the company’s stock price. Public companies have a large number of investors who pay close attention to business performance and actively trade its shares of stock. This gives you instant verification of market value as shares are bought and sold by all kinds of investors.
Besides, public companies are obliged to publish their financial performance results and explain to the public what their prospects look like going forward. All this transparency and audited data helps investors get a pretty good idea of what a public company is worth.
Private company info is, well, private
The situation is more complicated with privately owned companies. For one thing, private companies are under no obligation to disclose their financial results or business strategy to the public. Indeed, most business owners consider such information privileged and keep it under close guard.
Financial reporting for private companies is not uniform
To compound the issue, private companies are not required to comply with financial reporting standards, such as GAAP. If you are relying on comparable company profitability measures in your valuation, you may be comparing apples with oranges.
No market evidence of private company value
Sales of stock in private companies also tend to fly under the public’s radar screen. Only a certain class of well-off, professional investors is qualified to buy stock in private companies. Such private placements are governed by a raft of laws that exclude the general public from private business investments.
So there’s general lack of knowledge about the values of private companies, whether those that sell or attract outside capital.
Private business sales are under reported
Business brokers tend to be very competitive and shy away from sharing private company selling prices with each other or the public. In addition, selling a private company is difficult, and its price depends on the particular buyer and seller. This is nothing like calling your securities broker to sell shares in a public company. Private business sale is a major project that takes a lot of preparation and time.
The result of all these complications is that the average business person has little idea what a given private company is worth. Market data is sparse and unreliable, business financials are kept secret, and business selling prices are highly variable.
Choose valuation methods that work for private companies
So what can you do to ensure your business valuation holds water? In short, use the tried and true methods for private company valuation. Business appraisers have learned through the years to spend time in preparing for private firm valuations, then selecting valuation methods that produce consistent, dependable results.
Adjust financial statements to reveal the company’s earning power
To overcome the difficulties with financial results reporting, you would do well to adjust the financial statements in order to reveal the economic potential of the company. Business appraisers refer to this critical step as normalization. This way, you can start from the figures that can be used in your business valuation calculations.
Three ways to value any business
Just as with the public companies, valuation of private firms relies on the methods under the asset, income and market approaches.
Asset methods, such as asset accumulation or the excess earnings, are well known. In addition to calculating the value of a private company, such methods help you allocate the purchase price in a business sale.
You should apply market comparisons with care. If reliable business sale or valuation data on private firms is lacking, consider using similar public companies. There are plenty of small public firms that resemble their private counterparts quite well. The advantage is that the financial and business sale data is readily available and subject to audits and stringent reporting rules.
To account for the uncertainty of private company values, you can apply discount for lack of marketability, or DLOM for short. The idea with this method is to use the reliable data and then adjust your results for the difference between the public and private firm values.
Income based valuation methods are the typical choice when valuing private firms. You can calculate the value of any company, public or private, by using the well known discounted cash flow method. In addition, the classical private company valuation methods are available, such as the multiple of discretionary earnings.
Choose several methods to get accurate valuation
Picking a few methods under each approach is an excellent idea as it helps you zoom in on key value drivers. Your business valuation would truly stand out if it shows solid thinking and attention to detail that the different methods provide.
Methods for Private Company Valuation
Are you troubled with the results you get from your business valuation? It is not uncommon for people to have an expectation before the business value analysis is completed. When the results you get are way off base, you may wonder what went wrong.
This may be the case whether you do your own valuation or hire a professional appraiser to do the job. The most likely reasons for unexpected business value results are these:
- Unreasonable expectations.
- Poor quality data used as input into your value analysis.
- Limited selection of methods in your calculation of value.
Business people often have goals for the business. For example, business owners planning on retirement may want a certain sum from business sale. They are disappointed if the business appraisal indicates the company is not worth as much.
The best thing to do here is to approach your valuation with an open mind. Business value is not cast in concrete. It changes over time. The best part is that you can increase business value once you learn what the company’s value drivers are. Achieving the desired value for your business should be part of the overall exit strategy.
Business value is primarily about its earning capacity and risk. If the data you put together fails to disclose the business earnings prospects, your business valuation results can be misleading. Take extra care to review your earnings forecasts. Do the numbers represent realistic goals? How will this level of earnings be achieved? What else can the management do to increase the business earning power?
The risk is the other key input that affects your business value directly. Companies with competitive products and services in growing industries are at lower risk than those competing against a few large firms in a shrinking market. A wide range of products tends to help the company make up for the inevitable changes in demand for specific products. A strong management team in charge of a motivated, skilled workforce is the most valuable asset for any company. Carefully consider how the business is positioned to achieve its earnings objectives while operating in a competitive marketplace.
There are a number of business valuation methods to choose from. Skilled appraisers use several methods because this enables them to calculate business value from a set of different perspectives. For example, the asset based methods focus on the valuable assets in company’s possession. The income methods emphasize the earning power and risk of running the company. On the other hand, the market valuation methods compare your company against similar firms whose value is already known.
Using a set of methods is always a good idea. If the various calculations produce widely different results, you have to question your assumptions and reconcile the differences. For example, the company may have highly prized assets such as intellectual property, but be struggling to put them to good use generating profits. So your income based valuation may produce disappointing results.
If you choose to use market comparison in your analysis, be aware that no two businesses are the same. The market valuation looks at company value from market evidence. In a sense, your company is assumed to be the same as any other in your selected data set. Market approach is good as a sanity check, but may well miss the value drivers that make your company unique.