How to Value a Business
There are a lot of misconceptions about how to value a business. Most of these are related to the "Rule of Thumb" method of valuing a business. This method values businesses based on some tenuous relationship between price and various variables. These variables may be number of customers, beds in a private hospital, rooms in a motel, or a multiple of turnover for a radio station.
The rule of thumb method is very similar to the "Market Method" The market approach draws comparisons to publicly traded companies or private companies that are similar to the subject company. The market approach uses empirical evidence of value using databases for private businesses and companies. A major disadvantage with the market method is that it ends up comparing general information in the market, it is unable to consider specific factors leading to a specific transaction. It should be noted that even though the market approach uses empherical evidence of value, it is almost impossible to find truly comparable businesses. At best it is a "rough guide" and maybe useful as a checking mechanism when compared with other valuation approaches.
Business valuation should be very much reliant upon how much profit a business and an incoming purchaser can make, balanced by the risks involved. Past profitability and asset values are only starting points. Intangible factors, such as goodwill and intellectual property, also add value.
So, how do you value a business? The method that is the most technical way of valuing a business is the "Discounted Cash Flow Method".
Discounted Cash Flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
The discount rate used is generally the appropriate Weighted average cost of capital (WACC), that reflects the risk of the cashflows. The discount rate reflects two things:
- The time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay. Typically in Australia the 10 year day Treasury Note is used as a risk-free rate.
- A risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
There are other methods similar to the DCF method of business valuation, but I have found that it is a readily accepted method in judicial cases and one that is readily defensible. One of the drawbacks of this method is that it requires experience and knowledge to produce a business valuation based on this method. However, if you require an accurate and comprehensive business valuation, this is the method to choose. If you just want a vague inkling of what your business may be worth, then the rule of thumb or market method may well suffice.
If you would like a Valuation of your business, please contact Lee Goldstein