Overview:

Many companies incorporate business valuation into their regular management process, but not enough. Small and medium sized businesses are even less likely to perform this analysis. While business valuation is a specialized area of expertise, businesses of all shapes and sizes can effectively incorporate business valuation into their management system. This is because Widgets Inc. does not necessarily need business valuation experts; it needs a management team with experts at valuing Widgets Inc.

One of the most widely accepted methods of valuing a business is discounted cash flow. In this method the value of a business is equal to the expected future cash-flows discounted to today’s dollars. Businesses that are currently preparing multi year forecasts have already performed much of the analysis needed to do a valuation as they have solved for the expected future cash-flows. The remaining challenge is determining the cost of capital, which is primarily based on the risk associated with achieving the underlying forecast. Cost of capital is used to convert forecasted returns into today’s dollars by accounting for risk and the time value of money.

Assume Widgets Inc. has a cost of capital of 14% and projected returns of 1,000, 1,100 and 1,200 in years 1, 2 and 3 respectively. No returns are expected beyond year 3 and the assets will have no salvage value.

Projected Future Cash Flow: Y1: $1,000 Y2: $1,100 Y3: $1,200

Discounted Future Cash Flow*: Y1: $877 Y2: $846 Y3: $$810

Total Value: $2,534

Determining the cost of capital for a privately held company can be very difficult and is more of an art than a science. Every company has its own unique cost of capital but can look towards established benchmarks to find a good starting point. A number of organizations estimate cost of capital by N.A.I.C.S. (North American Industry Classification System) codes. Company size is another high-level factor considered in benchmarking cost of capital. Once a suitable benchmark has been found management can adjust this number based on company specific risk factors.

Reasons for Performing Valuation:

As part of a comprehensive financial management system, the valuation process will serve two basic functions. First: At some point all businesses will need to put their value on a piece of paper; this could be to facilitate a change in equity structure or to meet a legal obligation. Second: Valuation can be a decision making tool as managers should always make decisions based on maximizing shareholder value.

Scenarios in which a Business will NEED a Valuation

There are a number of events that require a company’s ownership to determine its value. Being prepared for these events in advance will place management in a position to make informed decisions in a timely manner.

1. Buying, selling, and merging – The sale of a company requires that the both parties agree on a value for the company. The window of opportunity to buy or sell a company may only be open for a short period of time. A current valuation will allow you to act quickly with solid information.

2. Raising Capital – When attempting to raise capital from an outside source investors need to have an idea of a companies worth. This will go towards determining the price that outside investors pay for shares.‬

3. Estate Planning – Without a valuation process in place a many family owned business are unaware of future estate planning obligations. The value that the IRS places on a business may not be in line with the realities of that company. Having a accurate valuation will enable to new ownership to argue their case more effectively if the value of the company is in dispute.‬

4. Litigation – A legal matter may require that the value of a business be estimated. Typically a third party expert will be asked to place an unbiased value on the business. If company management is experienced in valuation they will be able critically examine this expert opinion.‬

Business Valuation as a Management Tool

A valuation is not only useful in the event that one is needed for the reasons listed above; it can also be an invaluable management tool for both strategic and tactical decision making.

When operating in a fast paced and complex business environment, managers frequently focus on myopic measures of performance. At the end of the day all businesses should be managed to maximize value. A regular valuation process can serve as the capstone on an effective financial management system because it will keep management focused on the most important factor: value. Company leadership will better understand the "managing to value" concept when they are able to see how the dynamics of the business impact the company’s value. This will help them make better long-term and day-to-day decisions.

Most practical business decisions are not cut and dry. Different business strategies will have different investment requirements, potential returns, time frames and risk factors. Business owners struggle to make their decisions based on the right criteria. A valuation is the ultimate summation of financial analysis as it converts potential future returns into today’s dollars while accounting for risk. This type of analysis can serve as an outstanding decision making framework as two completely different projects can be evaluated on the same terms. All meaningful strategic decisions should to be evaluated in this context.

Revenue Multiples:

Revenue multiples are frequently used to estimate the value of a business. If Widgets Inc has revenues of $5 million dollars and ABC Widgets sold for 2 times their revenue, management at Widgets Inc. might think their business is worth $10 million. This type of analysis assumes that everything other than revenue (cost, expense, growth potential, risk factors) is the same. So while revenue multiples provide a valuable form of shorthand for financial professional it provides little meaningful insight to a company’s management.

Conclusion:

The entire process of placing an accurate value on a company may seem daunting. The reality is that it can be broken up into a number of manageable steps. For more specific information about the valuation process and the different valuation methodologies take a look at our valuation white paper (see link below).

By: Nick Sordoni

PlanGuru Associate

New Horizon Technologies