How much is your business worth? There are some fundamental truths about undertaking a business valuation. In this three-part series, Kevin Lovewell provides a simple explanation of business valuation methodologies and debunks some of the myths surrounding valuation techniques. He begins here with a history of valuation, an introduction to the most common techniques, and why an estimate is important for your business.
What does Business Value refer to?
The value of a business has traditionally been considered to be equal to the sum of the assets or physical resources owned or controlled by the business. Analysts, shareholders and business owners use the financial reports provided by a business to determine with relative confidence what a business is worth.
Another way of contemplating how to arrive at the “value” of a business, is to refer to the monetary sum a willing buyer is prepared to pay and a willing vendor is willing to take for that business. In this context, value of the business is certain and agreed to.
However, why do we confront this transparently simple question of “business value” with expensive and time-consuming analysis? Why do we often turn to licensed experts with their complex legal disclaimers? And why is such a significant amount of research and due diligence needed to determine what a business is worth?
A brief history of value
It is generally accepted that the 1830s heralded the transition from an agrarian (farming) society to an industrial economy. As a consequence, the output of machinery became the focus of the economy, society and business. Commerce and industry became economic drivers. In fact, by the late 1800s, all the tools used today in the fields of cost accounting and management accounting had been invented.
Value was measured in terms of property owned by the business (assets less liabilities). Arriving at business value was as simple and straightforward as establishing the value of net assets in the balance sheet of the business (also referred to as the owner’s equity).
The 1960s brought forth a transition from the industrial to the intellectual economy. Intellectual refers to activities relating to knowledge, creativity, and collaboration of the workforce that leverage the operating systems (not ownership per se of the assets of the organisation).
A very good indicator of this transition from industrial to intellectual economies is that the output of the mind occupies the functionality of the majority of workers today. Nearly eight out of ten workers now produce services rather than “things”. Even products (tangible goods) are primarily purchased on the basis of intangible explanations such as brand, reputation, service levels, etc.
Value today is largely outside the books
In 2005, Stern School of Business (NYU) completed a study that investigated 3,500 companies (not a small sample size). The study set out to measure the correlation between “book value” and “capitalisation” over time (i.e. the value of net assets shown in the balance sheet, and its relationship with the price shareholders were prepared to pay).
The study established that as of 1978, there existed a 95% correlation between the balance sheet and capitalisation. There was a very close relationship between the balance sheet value and the share value.
However by 2005, the correlation had fallen to 28% for the same 3,500 companies. Examined another way, 28% of the companies’ perceived value was explained by the physical net assets, while 72% of the “things” that created value were unexplained, not identified, intangible.
Our accounting measurements such as ROCE [Return on Capital Employed], COGS [Cost of Goods Sold] and other familiar metrics explain much less today in our intellectual economy than they did when they were invented for the Industrial economies of the 1800s.
Consequently, it is not surprising that conventional endeavours to uncover “value” are only attempts to make “tangible” what is “intangible”, because increasingly and ultimately the pure financial methods of arriving at the value of a business are virtually meaningless.
Why perform a business value exercise?
Having stated that financial metrics are less than effective in determining value, why provide an explanation of how to use them?
When we view the statistics freely available in respect of company buyouts, and transfers it is not surprising that we find 80% of mergers and acquisitions do not add value. In fact 50% of them actually destroy value. (Big bucks for consultants – less than impressive returns for shareholders). This is one main reason that we embark upon business valuation exercises. There will always be a role for establishing what is a fair value, due to the constant flow of businesses changing hands; Someone has to make the decision what is a fair price!
The fact is, estimating your business value is necessary in order to answer several important questions:
- Is my business “worth more” now than last year?
- What should I insure my business for?
- What is my capacity/ability to borrow funds?
- What should I set as my asking price if I want to sell my business?
Valuation methods
Despite many years and numerous variations in establishing the value of a business, there are only two principal methodologies:
- valuation by looking to the assets of the company; and
- valuation by looking to the cash flows the company has provided or can provide to the business owners.
We cannot deal with all the possible methods available, as they generally reflect academic and scientific views rather than practical analysis.
Although it is true that different valuation methods arise as a consequence of attempts to solve particular problems or issues within businesses or industries, the variety of methodologies now available do not stray from these two principal valuation methodologies.
Using valuations (however arrived at) as a basis of comparison between businesses or industries is also important for business education and management purposes. Is one business “better” than another? Is a particular business more or less valuable than its competitor in another suburb? Can we learn the secrets of a competitor – how did they make their business valuable?
The trend is my friend
In establishing value it is important to compare the results you have with some form of benchmark. This is why we have “rules of thumb” such as “times earnings” (mentioned later in this series); it is also why accountants derived ratio analysis (such as Gross Profit, Net Profit, Return on Equity, Return on Capital Employed). These indexes and trends offer very illuminating information about businesses over time as a result of comparing the business you are interested in against comparative available detail.
If there is one thing we have learned, it’s that it is important to be optimistic about the future, but the past is (unfortunately or fortunately) a more common barometer of the future in most business cases.
The price that similar businesses have sold for may not provide any sound or meaningful support for you, but it remains for you to establish and substantiate a differing opinion; and trends (measurement over time, or measurement across businesses or industries) should form part of the ammunition used.
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In my next article, I go through the most practical valuation methods and review the benefits and disadvantages of each, so that you can determine the best criteria for performing a value estimate for your business.
Kevin Lovewell is the owner of Corporate Solutions (Aust) Pty Ltd, a Fellow of the Institute for Independent Business and a CMT accredited Master Mentor.
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