Surprised? Then consider a typical situation calling for a business valuation – a company put up for sale. Business owners are proud to discuss the past track record of the business and especially how much money they were able to make.
Business value is in your dreams
Business investors and buyers look at the company from a different perspective. For them the question is about the expected future earnings. Historic track record is useful to the business investor only as a guide to help with the income forecast. The money anticipated to land in the bank is why the business buyers are even interested in acquiring a company.
Business value is in the eyes of the beholder
Think the past earnings are a reliable guideline for future income expectations? Not necessarily. Consider a Silicon Valley classic case of a technology start-up being acquired by a Fortune 500 public company. Odds are the real reason behind the acquisition is to get access to the cutting edge technology and top engineering talent. It’s an asset sale, basically.
Once the Fortune 500 company completes the acquisition, things swing into gear. The start-up is transformed into a brand new business unit and changed beyond recognition.
Business value – reaching for the stars
If you think about it, the forecast of future earnings made by the Fortune 500 acquirer is beyond the reach of the start-up acting alone. The public company has at its disposal the market access, established distribution infrastructure, customer loyalty, capital, and economies of scale the start-up could only dream of.
The link between business value today and future earnings
So far, so good. But how do you figure out what the business is worth today with all those future earnings looming nicely on the horizon? In fact, the business valuation toolbox has just the valuation method to do the trick. The discounted cash flow technique lets you establish the connection between the future earnings forecast and what the business is worth in present day dollars, right now.
The discounting magic needs one more key input from you – the discount rate. This number represents the risk associated with the business. Remember, the money has not yet landed in your bank account. The expectation of income could disappoint if the company falls upon hard times and hits unexpected difficulties down the road.
The discount rate essentially captures the risks inherent in future expectations – not getting the money when you expect it, falling under the rosy earnings forecast, or perhaps not getting a penny at all.
Business valuation and risk assessment – leave no stone unturned
Number crunching with the discounted cash flow valuation method could prove addictive and, somewhat disconcertingly, misleading. This happens when you omit some key anticipated business risks while creating your earnings forecast. Start-ups like to think of themselves as poised to dominate the world. A pile of money is just around the corner.
Then the reality sets in. It turns out the competition is not sleeping after all, and production delays are a real setback. Customers may be skittish about adopting new products from an obscure young company. Or the market becomes dominated by a few well funded competitors.
So the takeaway is this – you can run your business valuation based on future income expectations. Just make sure your forecast captures the business risks your company is likely to face.
Whenever the subject of business valuation comes up, the notion of valuation multiples is sure to follow. Business people and professional appraisers are quick to point out their favorite valuation multiples for a ballpark estimate of business value.
Business sale comps – market barometer of value
What is behind the popularity of these valuation tools? In short, the widely shared belief that the market is the ultimate judge of what a business is worth. All valuation multiples are derived from the market place. They establish a relationship between the business selling prices and well known financial performance metrics.
Business people tend to have their preferences when it comes to valuation multiples. The common ones are these:
- Business enterprise value (EV) to gross revenues or net sales.
- Enterprise value to EBITDA.
- EV to total business assets.
- EV to owners’ equity.
- EV to net cash flow (NCF).
- EV to seller’s discretionary earnings or SDE.
Key Question: what price can the business sell for?
In order to figure out business value, you could expose the company to the market to see what offers you attract. That’s a highly labor intensive and expensive proposition if all you want to do is to establish the value of the business.
Absent direct market tests like this, the next best thing is to compare your company to similar companies that have actually sold recently. Let’s assume you can get your hands on the business sale prices and financial statements of several companies in your industry and your specific market. Now you can calculate the valuation multiples from these comps and use them to estimate what your target company is worth.
Fair market value – the going rate for business selling price
The notion of fair market value is what makes such comparisons possible and highly useful. Market participants, i.e. business buyers, investors, and business owner sellers tend to be smart people who bargain in their best interests. The result of business sale deals closed by these intelligent people is always a compromise. You give and take to get what you want.
As a result, the market for business sales sets an equilibrium of sorts for the going rate of a given business. The formal name for this is the company’s fair market value.
Using valuation multiples from similar sold companies gives you the tools to get at the fair market value of your business without actually going through the motions of trying to sell it.
Where do valuation multiples come from?
So far, so good. But what options do you have to get at reliable business sale comps? There are several ways to go.
Source No 1: Past business sale transactions
If a privately owned company sold in recent past, the price paid in such past transactions is a decent indication of its current business value.
Source No 2: Guideline public companies
Another approach is to look at the published valuations of publicly traded companies in your industry sector. Many mid-market private businesses are quite comparable to smaller public companies in operational and financial terms. There is one big difference though. Shares of public companies sell on the open capital market. On the other hand, a privately owned company rarely if ever offers its stock for sale. Such sales are typically reserved for accredited investors through carefully orchestrated private placements.
Since investors abhor stock that cannot be readily sold, they set a cap on what the private company is worth. The difference is known to business appraisers as the discount for lack of marketability or DLOM for short.
You can thus develop valuation multiples from similar public companies as follows.
First, calculate the multiples from the known valuations and financial performance of guideline public companies.
Next, discount the valuation multiples thus obtained by the appropriate DLOM number.
Source No 3: Private business sales
You can also research the results of private business sales in your market. Direct comparisons to companies like yours are a good way to assess your business value. Be careful when selecting business sale data for your comparisons, though.
Most of the private business sales that surface are reported by business brokers. Since brokers act as business sellers’ advocates, they may overstate the financial performance of the companies they represent.
Putting the best foot forward when marketing a business for sale is just a step away from exaggerating its financial track record in order to get the top business selling price. Caveat emptor is the name of the game when gathering private business sales data.