Archive for August, 2018

This may be obvious to the professional appraiser, but many business people often wonder – why are business earnings forecasts such an essential part of business valuation? Shouldn’t a business be valued on its historic financial performance record?

Why do a business valuation?

Think about a typical situation in which a business needs to be valued – a business sale. An established business would undoubtedly have a solid track record of financial performance. Even if the receipts come from the proverbial shoe box, the company’s CPAs work hard to assemble detailed financial records to file taxes. So the business owners can turn either to their bookkeeper or accountant to get a copy of the income statements and balance sheets dating back a few years.

Business value is in its future earnings

The business buyer can glean quite a bit from the historic financials. But a business is never bought for its historic earnings. If you are buying a business, you are after the future earnings you can expect to get.

This expectation is key – the business buyers do not benefit from past earnings – only from the future ones. The expected money is not in the bank yet, so the business buyer needs to estimate what the business can produce going forward.

As you can see, the business buyer is really interested in what the business will bring in the future. Hence, the need to forecast business earnings.

Business risk – the second key to business valuation

Since any forecast is uncertain, you also need to estimate business risk. In business appraiser’s terms, your business valuation begins with forecasting business earnings and assessing the company’s risk in the form of discount and capitalization rates.

Take a close look at the workings of the venerable discounted cash flow method. This esteemed income-based valuation technique lets you calculate the business value directly from the earnings forecast and the discount rate. That’s right, the expected future business earnings and risk estimate are the inputs that drive the business valuation result here.

When in doubt, run what-if business valuation scenarios

Sure, no one has a crystal ball, so all future expected earnings are an educated guess at best. If you have doubts about the accuracy of a given earnings forecast, take a look at the underlying assumptions. What may seem a reasonable income stream under one set of assumptions may appear unfounded if the assumption set is changed.

Professional business appraisers have a trick up their sleeve when dealing with particularly challenging business valuation situations. If a single earnings forecast seems questionable, the business appraiser generates several, one for each set of assumptions.

Imagine a business that needs a government approval to launch a new product line, such as a medical equipment manufacturer. If the government agency, for example the Food and Drug Administration, grants the approval early on, the company can enter the market and quickly ramp up its revenues with the cutting edge products.

If, on the other hand, the FDA drags its feet over the approval, the company’s product introduction stalls, and the revenue outlook may look less promising.

You can’t tell for sure which scenario will prevail, so you cover your bases by creating two distinct earnings forecasts. You then use each forecast numbers to calculate what the business is worth today, in present day dollars.

You can further express your opinion of business value by assigning the weights to each business valuation result and calculating an average based on the two expected outcomes. This weighted average number represents your current thinking about the business value.

Thinking of valuing a company in the telecommunications industry? Consider some key industry stats:

This large and highly diverse industry sector is classified under the NAICS code 517. In the USA there are some 50,600 telecom companies competing across a broad spectrum of product and service offerings. The industry as a whole generates a hefty $545.5 billion in annual revenues. The industry sector total employment is around 1,134,500 with a revenue per employee of $481,000 per year. The average telecom business does about $10.7 million in business annually and employs a staff of some 22 including technical professionals and administrative staffers.

Over 28,000 of companies in the telecom industry have 1 to 4 employees on their payroll. Of the total of over 50,600 firms less than 5,600 have more than 50 employees.

Where are the telecom businesses found? In the US, the highest density of companies in this industry sector is in California, New York – New Jersey, Texas, Florida, Washington DC, and West Virginia. Of course, just about every geography has a number of successful telecom firms providing a broad range of services to customers around the world.

Business valuation of telecom companies

Telecom industry is very competitive and successful businesses are highly sought after as acquisition targets. Selling prices of such companies are used as an indicator of market values for similar businesses.

You can compare a target telecom company to its sold peers by calculating the ratios of business selling prices to a number of financial performance metrics. The ratios of selling prices to financial performance figures are known as valuation multiples. The multiples so derived help you develop an idea of what a given telecom company is worth in the market place.

One of the most useful valuation multiples is business enterprise value to its gross annual revenue.

Business valuation of a telecom company – an Example

To show you how this works, let’s pick a middle of the road telecom business with an annual gross revenue of $10 million and inventory of $1 million. Next, we choose a set of reasonable valuation multiples and crunch the numbers. Here are the results:

Multiple Multiple value Business value ($’000)
Low 0.46 $5,608
High 1.18 $12,767
Average 0.66 $7,599
Median 0.62 $7,195
Average Business Value $8,292

Note that we have added the value of inventory to the result of multiplication. This is common when valuing businesses with widely varying inventory levels.

Telecom Company Valuation

Recently observed business selling prices give you the real world data on which to base your own valuation. There is nothing more credible than the prices paid for similar businesses. You can calculate a number of other valuation multiples such as those based on net profit, EBITDA, or business assets.

See Example