valuation
Business VALUE Basics
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by Rich Barkley – Financial Advisor, Prime Capital Investment Advisors
Most small business owners spend the majority of their lives running their largest asset, their business. Then, when they transfer/sale, more than likely, it is one of the most critical transitions. To optimize this transfer, a business valuation should be considered. In the last article I wrote about Asset Allocation and where these micro businesses fit into the business owner’s financial plan. A professional valuation is one of the best starting points to prepare for this journey. A simple investment characterization is frequently defined as return over risk. The level of risk and return determines the value. There are several critical tangible and intangible value drivers that determines risk. How is value derived, how do operational, managerial, financial and strategic decisions ultimately affect value? These questions are not complicated but are complex and each business owner is different but ultimately affect the value. We as Certified Valuation Analysts have a detailed process that assesses the risks associated with specific businesses within certain industries and/or sectors and then apply the risks to the benefit stream / revenue. Formal (certified) valuations have a specific place in the business world. A formal valuation is helpful to assist in determining the most accurate benefit stream/cash flow (revenue), assessing the associated risks and comparing similar business sales and metrics. The Valuation Formula The formula for a business valuation is Value = Future Cash flow / Risk to Achieve Future (projected) Cash flow. Cash flow is something most business owners understand. However, risk is very much overlooked and misunderstood. This is why it is a common misconception amongst business owners that the value of their business is determined solely by revenue / cash flow or just an industry multiple. It’s actually related to the overall ability and risks of the business to produce revenue and free cash flow in the future. Businesses with the same sales and cash flow sell for significantly different amounts due to the level of risk. That’s why the simple multiple of EBITDA is not always the best approach. Business Valuation Approaches There are three main approaches to business valuation: the income, market, and asset approaches. Choosing which approach is best, depends on the type of business and reason for the valuation. Income Approach as defined by Valusource This is the preferred approach used for business valuations. It is based on calculating what the future cash flow to the owner of the business is worth today, also
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B oerne B usiness M onthly | November 2020
called the “present value,” or the “discounted cash flow”. The advantage is that the predicted cash flow and the risk to achieve that cash flow are related directly to the current operational state and, therefore, directly affects the value of the business. When you look at business sale data, it tells a compelling story of what businesses sell for and how much more a better performing business is worth to a potential buyer. A “better performing” business means a business with similar revenue and cash flow is selling for more (or even, much more) than its peers... Part of our job as advisors is to dive deep into how the numbers compare with their peers and the businesses internal systems and processes and then, in a sense, rank the business and identify comparable strengths and weaknesses. Market Approach The market approach is the most common approach in valuation. The best evidence of the value of a business is the market, or what other similar businesses have sold for (think of the MLS® system for residential real estate). The market approach looks at what similar businesses have sold for and then uses multiples (to adjust for size) to determine the value of a business. The disadvantage is that it is difficult to find a directly comparable business. Usually, businesses are compared as to product/service, size, and geography. However, it is very difficult to compare the competitive advantages of one business to another even if both sell the same product, are the same size, and operate in the same geographic area. Asset Approach The asset approach looks at the value of the business in terms of the market value of its assets only. To accurately determine the value of the assets an appraiser may need to be hired. For most service-based businesses, the assets (furniture, fixtures, and equipment) are small, but other types of businesses like a manufacturing company may have substantial assets. The advantage of the asset approach is that it will establish the lowest value of a business. The disadvantage of this method is that it does not really establish the highest and best use value of the assets in the business. Certified Valuation Analyst (CVA) One important thing we strive to do is help business owners understand the business valuation “roadmap”, meaning the range of what businesses sell for and equally important, how their business compares to the competition. This means providing them the range of values (ballpark figures) based
