The goal for many entrepreneurs is to scale and sell their business. Before you can sell it, however, you have to know its value. Understanding how that value is calculated can go a long way in helping you achieve that goal.
The first thing to know about valuing a business is that it’s not a perfect science. All valuation methodologies require judgment. Also, the many elements of risk must be considered, often leading to a more artful valuation process.
Despite the judgment required, it is important that to the greatest degree possible assumptions are based in fact. Business valuations work on the ‘garbage in, garbage out’ principle meaning pie in the sky estimates won’t (unfortunately) make your business more valuable. The more verifiable the assumptions are, the more robust your valuation will be, increasing the likelihood that a potential buyer will value your business within the same ballpark.
There are a number of valuation approaches available, but for learning purposes we will stick to the two most fundamental, and perhaps most relevant: asset- and income-based.
The most basic asset-based valuation methodology is referred to as the liquidation method. This method measures the fair value of your business’ net assets. Essentially, it is the calculation of what you would net if you were to immediately sell the assets of your business on the open market and settle your liabilities.
The tricky part in using this method often lies in the estimation of the fair value of your assets. In many cases, you can estimate the value of your assets based on public listings of comparable assets. Therefore, the more liquid your assets are, the easier they will be to value. Valuing intangible assets such as trademarks and customer lists is significantly more complicated and will almost always require the input of a professional to calculate.
This method is most appropriate in a business with erratic or negative earnings and cash flows.
The two primary business valuation methods under the income-based approach are the discounted cash flows (DCF) and capitalized earnings methods. The underlying concepts for each of these methods are comparable as they both attempt to measure net resource inflows in perpetuity. However, the application of these methodologies differs significantly.
Discounted Cash Flows (DCF) Method
The starting point of a DCF valuation is a cash flow forecast. An analysis of your business’ historical cash flow may help you identify trends that will allow you to forecast cash flow in future years with greater certainty.
In order to make cash flows realistic, one-time expenses that are not indicative of normal business operations should be removed. Examples of outflows that (hopefully) fall into this category are restructuring charges, costs associated with lawsuits and losses from natural disasters. Once these items are accounted for, cash flows are said to have been normalized. However, since depreciation is excluded from cash flows, an annual sustaining capital expenditure figure must be estimated and included in order to take into consideration the cash requirement for replacing capital equipment.
Typically cash flows are forecasted on a detailed basis for a five-year period. Given the uncertainty of forecasting further into the future, a blanket rate called the ‘terminal rate’ is applied beyond that time frame, in perpetuity. Accordingly, the terminal rate should be estimated conservatively.
Once the forecast is established, it must be discounted to adjust the figures for the time value of money. As the adage goes, a dollar today is worth more than a dollar in the future. Therefore, in order to calculate the value of those cash flows today, each year’s cash flows should be discounted by applying the following formula:
where r is the discount rate applied and n is the number of years between now and then. For an even more accurate end result, a monthly rate can be used (r / 12) over n months. However, in the fifth, or terminal, year, the following formula should be applied:
where g is the terminal growth rate.
Determining r can be somewhat complicated but perhaps the best estimation of it is your company’s weighted-average cost of capital (WACC). WACC is calculated by determining your business’ cost of borrowing cash; the interest rate charged on your debt, plus any dividends paid to shareholders:
where i is the average interest rate you pay on debt, T is the applicable corporate tax rate, and d is the rate of dividends paid.
WACC is a good metric to use because it factors in the actual premium charged by lenders and equity investors based on the risk in your business model. After applying this rate in your discounting calculation, you can aggregate the present value of each year, which will leave you with an estimated value of your business.
The DCF method is most appropriate when cash flows are positive and follow a trend or can be forecasted to a degree of accuracy that is acceptable to the relevant stakeholders.
Capitalized Earnings Method
The capitalized earnings method is a simpler calculation, but may consequently result in a less accurate valuation.
The starting point is net operating income (NOI), or revenue less operating expenses. NOI must be normalized as discussed above, non-cash items like depreciation should be removed, and a sustaining cash flow amount should be added.
Up to this point, the calculation is very similar to that of the DCF method, but this is where it changes. Instead of forecasting using growth rates, the adjusted NOI can be used as-is. An alternative is to determine an average of the adjusted NOI for a (historical) two- or three-year period. Of course, only results from years that are representative of your business’ recurring operations should be included within the average.
Once you have established a reasonable adjusted NOI, you can perform the ‘capitalization’ that gives this method its namesake. This is accomplished by applying a multiplier to the adjusted NOI. One method of calculating the multiplier is to add a growth rate premium to WACC, and take the reciprocal of the result.
The growth rate premium is required because the expectation of growth is not factored in elsewhere, like it is in DCF forecasts. Therefore, this can be calculated in a similar manner as the growth rates used in DCF forecasts.
For example, if your company’s WACC is 8 per cent and an average growth rate of 2 per cent per year is expected in perpetuity, your capitalization rate would be 10 per cent. The reciprocal of this amount is 1 / 0.1 (or 10 per cent), which results in a multiplier of 10. Multiplying the adjusted NOI by this multiplier will produce an estimate of your business’ value.
The capitalized earnings method is most appropriate when earnings are positive and a growth premium can be estimated to an acceptable degree of accuracy. In practice, business’ values are often calculated using the average of two or more methods, which serves as a sanity check.
Valuation calculations are often complicated. This article provided some high-level background, but there are other far more complex factors to consider. Furthermore, additional valuation techniques exist and may be more appropriate based on the facts and circumstances of your business.
The methods described in this article are for understanding purposes only and you should always consult a Chartered Business Valuator before entering into negotiations. However, this learning should provide you with the tools necessary to decipher how the value of your business was calculated.
Photo Copyright: Melissa King