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How Do We Best Value a Business?

How Do We Best Value a Business?

On the surface, valuing a business should be a relatively easy task, not unlike selling a house perhaps. You can either determine the size of a business (just like you would count the square footage in a house) or look at similar businesses that have sold recently (just as you would look at comparative sales of houses in the same local area). As a possible third approach, you might look at the future earnings potential of the business (just as you would look at the rental income from a property which had tenants). These three methods work well in the housing market for several reasons:

A) The assets are easy to measure – size of land the house sits on, size and quality of house, with numbers of bedrooms, bathrooms etc.

B) Comparisons are relatively easy because there are usually lots of houses clustered together, some of which are quite similar in land and building size and configuration (and are therefore an accurate guide to value).

C) Rental incomes are relatively stable, meaning that future income streams are easy to calculate, assuming occupancy levels stay high or at least consistent, of course.

In the business market, these same three valuation methods are highly problematic because:

A) The assets are difficult to measure as they are both owned and rented, tangible and intangible (like people expertise and IP for example) and variously depreciated. There is also not necessarily a market for some or even all of the assets, even though a purchaser may want to buy “the business”.

B) Comparisons are often extremely difficult because no two businesses are the same and even if you can find something of the broadly equivalent size in a similar industry, they may be very geographically separated and have different products and/or serve quite different customers.

C) Future incomes are not always stable (and this may even be the case for past and present ones). In addition, some businesses may be able to predict income growth reasonably well but not profitability (which may be all that an investor or possible purchaser is interested in).

So, in summary, although businesses use the same three evaluation methods that are used in real estate, their usefulness in the business world seems to be highly questionable.

Before we look at this problem and what to do about it in more detail, let’s look at how these three business valuation methods are actually carried out in typical circumstances, as they are not carried out in exactly the same way as in the housing market.

1. The Asset-based Approach

The asset-based valuation approach is mainly used in “distressed” business situations. These businesses may be struggling, declining in sales and profits and therefore up for sale or even complete closure, if they cannot be sold as a going concern. As a consequence, the asset-based valuation approach is used to determine a company’s value by adding up its tangible and intangible assets (although tangibles will usually dominate). 

2. The Market-based Approach

The market approach is the most common way to value a going concern or relatively healthy business. It aims to create a valuation based on a multiple of the company’s past earnings — usually the last 12 months (or longer) of EBITDA (earnings before interest, taxes, depreciation and amortization). If you found that the last 12 months of EBITDA totaled $1 million and you selected a multiple of, say, three you would get a valuation of $3 million. The key here therefore is in determining what the appropriate multiple number should be. For smaller service businesses this may be as low as 1-2. For a larger, more mature and sustainable business in a less competitive sector it is likely to be much higher (in a range of 4-8 perhaps although occasionally companies sell at a multiple of 10, 15, 25 and even higher, especially in high tech areas). 

3. The Income-based Approach

The third approach – income based, is forward-looking, but focuses on the net present value (NPV) of expected cash flow. This valuation method is much more common in high-growth sectors like technology, where a company’s potential is much more interesting than its past track record or even current performance. However, prospective investors or buyers are always more skeptical about these kind of evaluations because of their speculative nature and as a result this valuation is often blended with one of those described above (or sometimes even both of them). 

So how do you value a going concern and what factors need to be taken into account?

All businesses should have a basic understanding of what they are worth once they are reasonably well-established. In other words, once a business has been up and running for a couple of years or more, is operating in its own premises and has multiple employees (and not just the founders) all being paid a fair market rate, a business should be worth more than its forced sale assets. As such, a valuation can act as a guide to how strong or impressive growth has been and how much this may need to improve. It also acts as a useful measure to the founders or management team of how much the business may expect to give away in equity to an investor should it wish to raise money or even to sell for in its entirety, in the event of a total exit strategy. As a consequence, not only should a business seek a professional valuation but should do so on the back of a rigorous audit of the entire operation, so as to know exactly where optimizing efforts are likely to yield greater value for it before an investment is sought or business sale takes place.

A rigorous audit means going well beyond the financial figures for the business (which are part of the process but only one aspect of it). This means that the business should be looking at the quality of its customers (and its prospective ones yet to be identified and won and not just the current ones). The business should also look carefully at its key processes or the ways in which it executes on its promises to customers. This will include tangible processes such as quality or product and delivery efficiency and effectiveness but should also include less tangible but nonetheless critical processes such as how innovation takes place across the organization and how sustainably products and services are provided. And last but not least before financials are considered, a business should look at its people processes – including how they are hired, trained and encouraged to give of their best in all circumstances and given a clear vision of the future in order to best align their efforts in the most productive ways possible. 

Most business owners or managers know how to carry out a basic financial audit, but such an audit will go beyond the useful profit and loss and balance sheet statements and major financial ratio analysis. In making an investment or buying a business, an investor will want to see “clean financials” (meaning no personal expenses and perks will need to be excluded) and will be interested in other factors which impact on long term profit potential. This includes the governance or control system used by the business, how business risks are measured and managed and how assets are acquired and then used.

Once a full and rigorous audit has taken place, a business can not only see where efforts to optimize may lie but where this is likely to lead to greater value in terms of overall worth, whatever the valuation method used. For example, new market segments or niches may be readily accessible with a little focus and effort, or new technology possible to use to improve one or more slow or costly processes. In the people realm, experience or knowledge gaps that are identified may be worth closing or better team working approaches may have a direct impact on either cost savings or revenue generation. The simple point here is that optimization efforts can and should be carried out (at least to some degree) by a business before investments in it are made. This ensures that the business will be financially stronger and the equity that will need to be given will be lower or the cash payout in a sale situation will be higher. 

A strategic investor or buyer will have his or her own vision for how to improve business operations. Although this means that they will look for opportunities that the business has missed, they will expect a business to have carried out some optimization effort and to have used the information to strengthen the management team, lifted quality of service, worked more closely with suppliers or at least considered new segments or niches that have the scope for future growth etc. All of this effort not only translates into a better bottom-line profit but may also raise the multiple on the most popularly used market-based valuation approach. For example, if EBITDA rises 10% to say $1.1 million and a multiple goes up from 3 to 4, this will lift a valuation from $3 million to $4.4 million (a rise of 47%).

Summary

The question we asked at the top was how we best value any business? Even though the three methods which work so well in real estate do not work so well in business, they are the best we have available and are used singly or in combination by most accounting firms, lawyers and business brokers (even though many claim to have their own sophisticated algorithms). In the final analysis the market based approach is by far the most popular (and still dominates even when used in combination with other approaches) so we should take both EBITDA and the multiple seriously. And as a business audit across the entire operation and subsequent optimization effort is the best way to have a positive impact on both of these numbers, this is the best way to get the best possible valuation.

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About Dr. Jon Warner

Dr. Jon Warner is a prolific author, management consultant and executive coach with over 25 years experience. He has an MBA and a PhD in Organizational Psychology. Jon can be reached at OptimalJon@gmail.com

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About the Editor and Primary Author

Jon Warner

Jon Warner is an executive coach and management consultant and in the past has been a CEO in three very different companies. Read more

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