In the last post, we discussed the interplay of selling your company and financial planning. A major discussion point in that email was the role that business valuation plays in planning. In this email, we will discuss approaches and considerations in determining business value.

Fair market value is defined as the price at which a company would change hands in a transaction between a willing buyer and a willing seller, both being reasonably informed as to all the relevant facts about the business, and neither party being under compulsion to buy or sell. A completed transaction unequivocally determines the fair market value of the company. However, the preparation of a business valuation for planning purposes does not have the luxury of a completed transaction to confirm fair market value; therefore, business value must be estimated.

Determining business value is often perceived to be a black box – input a bunch of financial information into a computer model and out pops the value of the business. It must be correct since it came out of the model, right? Wrong.
As described below, business value is determined based on a host of subjective non-financial inputs, as well as financial information that must be considered collectively to arrive at an informed conclusion.

Business valuation chatter includes buzz words such as “multiple of revenue,” “multiple of EBITDA,” and “discounted cash flow.” Many industries have their own “rules of thumb.” Retail chains can trade based on a multiple of stores. The skilled nursing industry often trades based on a multiple of licensed beds. A valuation metric in the asset management industry is percentage of assets under management. Ultimately though, all valuation metrics are based on
how much cash the company has historically generated, how much cash the company is expected to generate in the future, and the risk profile associated with realizing the expected future cash flows.
After all, in business valuation as in many walks of life, cash is king!

It is worth noting that “expected stream of future cash flows” has multiple meanings. It can mean the cash flow expected to be generated by the company itself, the cash flow that the company is expected to generate by being associated with a buyer, or a combination of the two.

In researching how to value their company, business owners may have read about various valuation methodologies such as the “income method” (discounted cash flow or capitalized cash flow), “book value,” and “market comparable value” (comparison of the company to publicly-traded companies). One or more of these approaches are typically applicable to each business, but they must be uniquely applied to the business to develop a valuation conclusion. The application of various valuation methodologies ultimately determines an inferred multiple of EBITDA.

Businesses in the same industry typically trade in a range of multiples. For example, if the business owner’s industry currently trades in the range of 6x to 8x EBITDA, what determines if the subject company will be valued at the lower end of range, the higher end of the range, or in between?

One of the biggest factors in determining the multiple is the magnitude of the company’s EBITDA. Companies with an EBITDA <$1,000,000 are typically valued at a lower multiple than companies with an EBITDA between $1,000,000 and $5,000,000. Similarly, companies with an EBITDA between $1,000,000 and $5,000,000 are typically valued at a lower multiple than companies with an EBITDA between $5,000,000 and $10,000,000, and so on. Other critical factors in narrowing the range of the multiple include proprietary products or processes, intellectual property such as patents, trademarks and brands, customer concentration, depth of management, investment and maintenance of equipment and IT Systems, and the quality and integrity of the financial reporting processes, among others. These non-financial “qualitative factors” uniquely influence the multiple. Two companies in the same industry with the same financial statements will be valued differently based on the evaluation of each company’s qualitative factors since these factors influence the perceived risk profile associated with achieving the expected future cash flows.

Business value is dynamic. The conclusion as of December 31, 2016 will likely be different than the conclusion as of December 31, 2017 and certainly different than the conclusion as of December 31, 2018. Business value changes based on internal developments and external factors including the economy, market sentiment for the industry, supply and demand, and consolidation activity in the underlying market. As a result, re-evaluating business value from time-to-time assures that the business owner is knowledgeable about their options based on real-time information.