Demystifying Business Valuation (Part II): The Power of Knowledge
Demystifying Business Valuation (Part II): The Power of Knowledge
In my last piece, “Demystifying Business Valuation (Part I)” I explained that, from a business owner’s perspective, valuation is a simple three-step process: Collect your documents. Educate the valuators on how the business operates. Then literally walk them through the business and show them how it’s done.
Now, we answer two key questions: What happens on the other end, when the valuators crunch the numbers? And what does the owner get out of the process?
As to the first, there are three common approaches to valuation, and a professional valuator should look at them all:
Asset-Based Valuation:
There are two key asset-based methods, and a professional valuation should consider both. “Book value” looks at the cost of the company’s physical assets, as reflected on the balance sheet. It’s essentially the net equity of the business. The approach has weaknesses: it doesn’t take into account intangibles, and it’s a historical measure that doesn’t consider current asset value (e.g., the book value of a depreciated asset, like a building, will be lower than current market value). This approach often establishes the lowest value, but it’s helpful in showing the historical cost of assets and whether the business earned or lost money over the years.
Adjusted net asset value builds off the book value, taking those numbers and adjusting them to reflect the assets’ fair market value (based on a fresh appraisal); it also assesses and includes the value of intangibles in the business. This approach often establishes a reasonable floor for what the business is worth. But once all the calculations are complete, if it’s the highest estimate, it could be the one that you go with.
Income Valuation:
There are a plethora of methods in this category, but they all share a common foundation: they’re based on the cash flow (i.e., the earnings) of the business. Two of the most important methods are “capitalization of earnings” and “discounted cash flow”:
- Methods like “capitalization of earnings” take a historical view. They use a rate (based on industry, risk exposure, etc.) to capitalize on past earnings and to create value. It estimates what rate of return an investor might expect to get by buying the cash flows the business is currently generating.
- Methods like “discounted cash flow” take a forward-looking view. They take a projection of future earnings and discount those earnings back to present value. A professional valuation will likely look at historical approaches, as well as forward-looking approaches (probably a couple of each). The valuator will use the one that makes the most sense for the individual business. For example, forward-looking methods may be more appropriate for start-up companies, or established companies that are expanding or launching a new product line: i.e., any company with a legitimate expectation that future earnings will be higher than present earnings.
Market Valuation:
The two general methods in this category are: prior transactions and public company comparables. Both are exactly what you’d expect, and both can be difficult to apply to smaller, closely-held businesses. Smaller companies, and closely-held companies, rarely sell parts of the business, so there’s often no history of sales transactions to establish a business value.
And public companies, even those that look similar on the surface, are often too different to provide a viable valuation guide — e.g., public companies have more access to capital, more intangibles on the balance sheet, etc. Now, the IRS prefers this method for things like calculating gift taxes, and valuators go through this process as part of their due diligence. But more than likely, market approaches won’t be relevant.
Finally, the last thing a valuator should do is what we call a “sanity check.” That is, take the estimated value and look at whether a prudent buyer who pays that price could earn enough out of the business to cover the debt service. If not, that’s a red flag that the valuation is out of line and needs to be re-thought.
Now back to that second question: What does the owner get out of it?
The valuator’s final report renders an “opinion” on the value of the business, based on their experience, knowledge, and professional education. It explains all the valuation methods considered, why certain methods were not applicable, and why the assigned value is the best fit for the company.
This last point is important. In the end, it’s not just a matter of which approach yields the highest price, but which approach makes the most sense for your specific business.
One of the biggest mistakes a business owner can make is to slap a generic industry multiple on their business—a multiple that could be an average of a thousand businesses. It offers no insight into where your specific business falls on that very large continuum.
A professional valuation gives you something very different: knowledge and power.
Based on rigorous analysis, and a lot of math, a professional valuation pulls you out of the dark, eliminates the guesswork, and shows you where your company is likely to fall on that large continuum. It also puts tremendous power in your hands: identifying value drivers in your business that can help you move your company toward the upper end of that continuum, in preparation for a sale.
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