In the complex world of business valuation keeping things simple may seem as a distant dream. Just think about the challenges faced in valuing a company: analysis of economic conditions, forecasting business earnings, assessing risk, choosing the right valuation methods and interpreting results that may puzzle the unwary.
With so many moving parts, it’s small wonder business valuations are often subjected to intense criticism. Industry mavens fret over the application of standards and ethical flaws perceived in some business appraisals. Business people puzzle over the results that don’t seem to make sense. Complexity born of necessity?
Not necessarily. For savvy business investors analyzing opportunities is second nature. They learn to sift through a pile of maybes by using tried and true methods that stood the test of time.
Income based business valuations cut to the chase by letting you focus on the core reason for running a business – putting money in your pocket. In addition to the amount of the cash expected to swell your pocketbook in the future, you would need to size up the risk. Risk in investment addresses this important question: how confident are you about getting the cash on time and in full measure?
Business valuation: risk and return are inseparable
So risk and return go hand in hand. The reason the income valuations work is because they match the two. Take, for example, the famous discounted cash flow method. You put your crystal ball before you and create a forecast of business earnings. To figure out the risk, you work up the discount rate. Now use the discounting math and the future expectations are translated into the so called present value. Witness the magic of sizing up your future expectations today.
Discounting vs capitalization valuations – the difference
The discounting math is known as multi-period. In other words, your forecast is done over several time periods into the future. The usual way is to predict cash flows for several years ahead, say 5 years. At the conclusion of which you make a leap of faith regarding the business value in perpetuity, known as the terminal value.
Sounds complicated enough. But wait, there is a simpler way. It is known as the single period capitalization method. What a relief!
Instead of all this fancy forecasting for years into the future, all you need to do is divide an earnings number by a capitalization rate.
Great, but does this really work as well? In fact, it does, provided one little assumption holds true. The complex math of discounting reduces to the simple capitalization if your business earnings are expected to grow at a constant rate.
Cash cow business valuation – life is good
How relevant this is to you depends on the business being valued. Imagine a cash cow that keeps chugging year after year producing predictable, steady income. This is a perfect example where a single period capitalization valuation makes sense.
Valuing a technology company
How about a high flying tech start-up? These companies may disappoint you in a jiffy. High earnings one year, a crash the next. Better stick with the complex discounting valuation to make sense of this roller coaster.
As the saying goes, the devil is in the details. Keep it as simple as you can. Just don’t skip the steps in your business valuation.