Ask any seasoned business appraiser and you will hear that business value is about future expectations. Business people invest in companies because they expect returns on their investment. Business historic performance is only interesting in so far as it enables you to estimate future returns.
Opportunity cost – making your best investment bet
Financial gurus refer to this concept as the ‘time value of money’. Given a bit of cash in hand today, you are looking to increase your holding by some future date. There are a number of alternatives in a properly functioning market. So you look around for the best bet to place your money on.
Business value is about future returns
The reason a business is worth anything, is that you can expect to receive more later than you invest today. For example, if you invest $100 today and expect to get $110 by year end, your return, expressed as a percentage or interest, is 10% annually.
Thus you figure on getting $10 on top of your investment in a year. In business valuation language, this is Net Present Value, i.e. the total return minus the initial investment.
You can take this idea a step further and calculate the Net Present Value (NPV) for a business investment project of any complexity over any time period. This is especially useful if the expected cash flow is lumpy and spread over a long time. You can compare investment projects and select the one with the highest NPV value.
Internal rate of return and hurdle rate: justifying your investment
Another technique used by professional investors is to calculate the so-called internal rate of return (IRR). It is the interest rate that sets the discounted or present value of the business cash flows equal to your investment. In simple terms, the internal rate of return is precisely what you need to justify your investment in the business.
Professional investors such as venture capitalists have an IRR in mind when screening proposed business investments, called the hurdle rate.
What your business investment is worth today: Present Value
Discounting future business cash flows to the present time is the foundation of any serious business appraisal. Whether you use the internal rate of return or the net present value in your selection, you have a consistent, reliable framework to compare business investment project side by side. Should you continue investing in a business, or do you spot an opportunity for higher returns making divestment attractive? You can use the discounted cash flow calculations to make well informed, rational decisions.
If you run across a business whose value seems to be too good to be true, you may be right. Since business valuation relies upon the estimates of business earnings, overstated earnings could easily be misleading.
While reasons for inflated business earnings are legion, here are the top five ones to watch out for when valuing a private company:
1. Deferred maintenance
Business owners may opt to use key assets to generate as much cash flow as they can. If the owners are planning on retiring or selling the business, they may deliberately neglect the need to repair or replace aging machinery or equipment. This distorts the cash flow picture while sweeping the required capital investment under the rug.
A new owner may well be stuck with high outlays trying to bring the business assets up to snuff.
Some business owners are masters at running their companies on ‘vapor’. They use generous credit terms from established vendors and aggressive receivables collection to reduce working capital requirements.
They may be able to raise long term capital from family or friends on terms unavailable from commercial lenders. For a new business owner, such terms may simply not exist.
If you are valuing a private company, carefully review the actual short and long term capital needs the business requires to operate successfully.
3. Understated payroll
Employees are the lifeblood of any business. Key employees must be well compensated to be attracted and retained. In a small business, these critical jobs are often performed by the business owners themselves who work for ‘sweat equity’.
If the business sells, the new owners will have to find a way to replace these critical skills. They may be shocked to find that the availability of such skills in the market is scarce or that the hiring cost is prohibitive.
4. Underweight marketing and sales expenses
An established private company may be relying too much on the word of mouth to keep running. Should the business need to enter new markets or defend against a new strong competitor, the funds to plan and execute effective sales and marketing campaigns may become a major drain on cash flow.
Carefully establish what the business needs to budget in order to promote its market position and reach existing and new customers. Then incorporate these requirements into the estimate of business earnings that ultimately affect what the business is worth.
5. Hidden operating costs
Successful businesses usually have a ‘trick up their sleeve’. This may be an innovative process that makes it highly efficient, or a line of products and services that attracts customers. The costs of internally developing such trade secrets can be considerable. However, they are typically not stated on the company’s financial statements.
Equally important, the skills and expenses associated with keeping the competitive edge may be unclear until you find out that the departing owners or their key employees take with them the essential part of what makes the company tick.
Missing these hidden cost drivers could come back to bite you when an obsolete product line needs upgrading and you find to your amazement that no one at the company knows what to do.
Whenever you run across a business appraisal for a privately owned company, the choice of discount and capitalization rates pops up. These parameters let you assess company risk, an essential element of valuing any business.
The income based business valuation requires that you provide an accurate estimate of business earnings along with the discount and capitalization rates reflecting business risk. Given the importance of these parameters, there are a number of well known ways to calculate them. Business appraisers refer to these calculations as cost of capital models.
In the language of business investment, the cost of capital is another way of saying that every company must pay for every dollar of investment it attracts. Investors study business risk and decide what sort of returns they should receive given other investment alternatives they could go with.
In other words, business risk and cost of capital refer to the same concept, described from two different points of view. Investment in a business is risky in that you can lose all or part of it, or not receive the returns you expect. Knowing this, you can rank investment opportunities according to the risk level and demand that the riskier investments promise higher returns. Creditors use similar logic, the higher the business risk, the higher the interest the company must pay on its loans.
The cost of capital then is what the company must pay for attracting and retaining required capital, whether from lenders or investors. Two of the best known models to calculate the cost of capital are the build-up and capital asset pricing model or CAPM for short.
CAPM is very popular to calculate the discount and cap rates for public companies. Their returns are known, so you can calculate the beta, which is just the correlation of the company total returns to the overall equities market.
This is problematic if you need to value a private company whose stock does not sell on the open market. Without reliable knowledge of stock prices you can’t calculate the beta that the CAPM model requires. The only way to estimate the returns needed for beta calculation is to run a number of business valuations over time.
In contrast, the build-up model uses the readily available data from the public capital markets. In addition, you can factor in the company specific element, known as company specific risk premium. Given this simplicity, the build-up model is far more useful when valuing private companies.