The Principals of a Business Valuation
How Do You Value a Business?
A Method to Calculate Business Valuations: Value Starts with Expected Cash Flow
In the context of a business valuation, value is based on the expected future cash flow of the ownership interest in a business or investment. A valuation professional might base their future cash flow projections on a company’s historical cash flow from tax returns or internal financials. Still, they only do so because history can be a predictor of the future.
Principle of Expectations
Under the Principle of Expectations, the valuator (be it a professional or layman) must deal with the uncertainty of the future. Are management’s projections reasonable and likely to happen? If you look at the company’s history and track record, do future projections seem doable? Do they make sense and stand up to the valuation reality test (which we discuss below)?
How do you calculate the expected value of a company?
Principle of Expected Value
If the Principle of Expected Value is our first tenet, the Principle of Growth is our second. You can look at the stock market and see that investors pay up for a higher growth rate, even if positive cash flow does not exist. For example, Amazon was negative cash flow for its first fourteen years of existence, and investors (mostly) kept paying up based on the Expectations of Future Growth.
But as we all know, Growth is not consistent or forever (Pets.com, for example). Our third principle is the Principle of Risk and Reward, or Greed versus Fear for the more street-smart. In theory, investors and potential owners will invest or buy in less risky investments, all things being the same. However, some discounts or its reverse, multiple, will give equal weighting to extremely low-risk investments, US T-Bills, versus a high-risk investment, in a pre-revenue start-up.
Principal of Risk
The Principle of Risk and Reward is based on the perceived fact investors expect a higher return on a riskier investment, everything else being the same. If the riskier investment did not pay a higher return, what would a buyer’s incentive be to overcome their fear or risk? Venture capital expects a 50-100 times return since most investments go belly up. In contrast, steadier T-Bills backed by the US government pay 2-3%.
The next Principle is the Principle of Present Value, which ties into all the Principles listed above. Simply put, a dollar now is worth more than a dollar in ten years. Think about the delayed gratification of a used car today versus a new car in three years after saving your money.
The Present Value Principle has four components that we touched on earlier:
- You invest in equities or a business because you expect growth over time in your investment.
- You invest in equity or business because you are expecting future cash flows. A professional or layman valuator (you) must understand the cash flow type, amount, and if it differs among shareholder classes.
- Your investment has a duration that meets your expectations at a certain valuation. Buyers and sellers argue over the number of future cash flows and their hypothetical duration.
- Different Risks have different Risk traits. Sellers are trying to minimize the risk in their company, while buyers are trying to show that higher risks exist, and they are trying to pay down accordingly.
I quote the eminent valuation expert Chris Mercer in his newest edition of Business Valuation, An Integrated Theory. “The Present Value Principle enables us to compare investments of differing durations, growth expectations, cash flows, and risks.”
The Principle of Alternative Investments
We all like alternatives. Well, maybe, is the world better with 800 TV channels versus 3? The Principle of Alternative Investments shares the realities of the multitude of potential investments for investors. There are 7600 mutual funds in the US alone. There are over 42,000 businesses for sale in the US. Investment choices are staggering, and all compete for investors’ dollars.
Valuation professionals also focus on the best buyer for a certain asset being valued. Sellers are striving for the 1+1 = 3 Strategic buyer. Sellers and their consultants are targeting and selling the synergies of their potential investment target. Buyers would prefer to be cash flow or financial buyers who are looking strictly at the target investments existing cash flow.
The Principle of Alternative Investments also touches upon opportunity costs. A potential buyer spends resources and time buying a company, and the deal does not close. All that time and resources are sunk costs that cannot be recovered. Also, management has spent time on the failed acquisition versus growing their core business. Taking your eye off the ball is a real problem and gets management fired.
The Principle is that of Rationality.
The last Principle is that of Rationality. In the macro, markets are rational and consistent. Of course, they get overheated and follow power laws versus the normal standard deviation curve during both the draw-ups and draw-downs. If you bought bitcoin at $64,000 and watched it plunge to $18,000, you may be tossing your smartphone after reading the above. People drown in rivers where the average depth is 4 feet. When researching and discussing the Principle of Rationality, take all the “rationality” with a grain of salt in times of massive drawdowns and hyperbolic expectations.
All valuation professionals worth their salt end their valuation report with a valuation reality or sanity check. For example, if you buy a business, put down 20%, and financed the remaining 80% for 7 years at Prime + 2%, would there be enough cash flow to comfortably cover the debt and still leave you with a return that meets your personal risk/return profile?
A business valuation encompasses these six principles. Both valuation providers and investors should understand how each ties together with the other.
Note: Much of this article uses concepts from Mercer’s & Harm’s Business Valuation: An Integrated Theory. We embrace many of those concepts at Business Appraisal FL|GA and find the integrated theory makes explaining business valuations to our clients and their advisors easier.
As a business owner, do you need help with your business valuation steps or what makes up business valuations? Please call or contact BA FL|GA.