Business Valuation Methods: What’s The Rationale?

Whats the methodology

 

Many owners ask me – how can they best value their businesses? Naturally, business valuation goes beyond simple mathematics – but to get some idea of what your asset might be worth, consider applying the methods below.

 

Your business is likely your largest asset, so it’s natural that you’re curious about its value. The only problem is that business valuation is what one might call a ‘subjective science’ – so if you’re looking for ‘hard and fast’ outcomes here, you’re best to put that idea to one side.

The ‘science’ part of business valuation is what people undertake further study to master: you can get an MBA or a degree in finance, or you can learn the theory behind business valuation and earn professional credentials as a business valuation professional. The ‘subjective’ part of the equation is that every buyer’s circumstances are different: two buyers could see the very same set of company financials and proffer vastly different amounts to buy the business.

This article provides you with the basic science and maths behind the most common business valuation techniques – but do keep in mind that there will always be outliers that fall well beyond of these frameworks. These outliers are referred to as strategic sales, where a business is valued based on what it is worth in the acquirer’s hands. Strategic acquisitions, however, represent the minority of acquisitions – so use the three methods below to triangulate a realistic value for your company.

Good Will Hunting

 

Assets-based (AKA ‘No Good Will Hunting’)

The most basic way to value a business is to consider the value of its hard assets minus its debts. Imagine a landscaping company with trucks and gardening equipment. These hard assets have value, which can be calculated by estimating the resale value of its equipment.

This valuation method often renders the lowest value for your company because it assumes your company does not have any ‘Good Will’. In accountant speak, ‘Good Will’ has nothing to do with how much people like your company; ‘Good Will’ is defined as the difference between your company’s market value (what someone is willing to pay for it) and the value of your net assets (assets minus liabilities).

Typically, companies have at least some ‘Good Will’, so in most cases you get a higher valuation by using one of the other two methods described below.

 

­Discounted Cash Flow 

Using this method, the acquirer is estimating what your future stream of cash flow is worth to them today. They begin by trying to figure out how much profit you expect to make in the next few years. The more stable and predictable your cash flow, the more years of future cash they will consider.

Once the buyer has an estimate of how much profit you’re likely to make in the foreseeable future (and what your business will be worth when they want to sell it in the future) the buyer will apply a ‘discount rate’ that takes into consideration the time value of money. The discount rate is determined by the acquirer’s cost of capital and how risky they perceive your business to be.

Rather than getting hung up on the math behind the discounted cash flow valuation technique, it’s better to understand the drivers of your value when you use this method. They are: 1) how much profit your business is expected to make in the future; and 2) how reliable those estimates are.

Note that business valuation techniques are either/or and not a combination. For example, if you are using Discounted Cash Flow, the hard assets of the company are assumed to be integral to the generation of the profit the acquirer is buying and therefore not included in the calculation of your company’s value.

A money-losing bed and breakfast sitting on a $2 million piece of land is going to be better off using the Asset-based valuation method; whereas a professional services firm that expects to earn $500,000 in profit next year (but has little in the way of hard assets) will garner a higher valuation using the Discounted Cash Flow method or the Comparables technique described below.

Oranges and Apples

 

Comparables

Another common valuation technique is to look at the value of comparable companies that have sold recently or whose value is public. For example, accounting firms typically trade at one times gross recurring fees. Home and office security companies trade at about two times monitoring turnover, and most security company owners know the comparables technique because they are often getting approached to sell by private equity firms rolling up small security firms. Typically you can find out what companies in your industry are selling for by asking around at your annual industry conference.

The problem with using the comparable methodology is that it often leads owners to make an apples-to-bananas comparison. For example, a small medical device manufacturer might think that, because CSL is trading for 20+ times last year’s earnings on the ASX 200, they too are worth 20 times last year’s profit. However, if compare similar sized companies, it’s clear that a small medical device manufacturer is likely to trade closer to five times pre-tax profit.

Small companies are deeply discounted when compared to their ASX200 counterparts, so comparing your company with an ASX 200 giant will typically lead to disappointment.

This is Business

 

Finally, the worst part about selling your business is that you don’t get to decide which methodology the acquirer chooses. An acquirer will do the maths on what your business is worth to them behind closed doors. They may decide your business is strategic, in which case back up the Armaguard truck because you’re about to get handsomely rewarded for your company. But in most cases, an acquirer will use one of the three techniques described here to come up with an offer to buy your business. Remember – it’s not personal. It’s just business.

 

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