When you think about valuation, think about it in terms of risk. How much risk would a buyer be taking on if they were to acquire your business? Many people think valuation is a simple financial calculation. Not so. Valuing a business is complex because of the diversity of companies, industries and individual business performance.
The true value of a business is what a buyer is willing to pay. This varies depending on many factors, such as how much cash is needed (usually two cheques – one for the purchase and one for working capital), the timing of payment(s), whether there is some special intellectual property, what the future industry growth prospects are, whether you have strategic value to the acquirer and so on.
Most default to thinking valuation is a multiple of Earnings Before Interest, Tax, Depreciation and Amortisation or EBITDA, using industry “rules of thumb” based on historical and/or comparable sales.
From a buyer’s perspective it’s about how much risk is involved in maintaining your projected future profits and clearly identifying future growth prospects.
Typical Approaches to valuation
There are more than 10 commonly accepted methods for valuing a business, including: book value; adjusted book value; discounted earnings; discounted cashflow; income capitalisation (net profit before tax); sales multiple; seller’s discretionary earnings (SDE) multiple; and price/earnings ratios.
SDE is typically the net income (or net loss) on the company tax return + interest expense + depreciation expense + amortization expense + the current owner’s salary + owner perks.
The most commonly used valuations are a straight multiple using EBITDA and Discounted Cashflow (DCF). DCF factors in future income projections at a discount (risk tolerance) to today’s value.
Micro-businesses sold to an owner/operator are usually valued at one to two times net profit but buyers sometimes pay a higher multiple depending on accepted industry benchmarks and strategic fit with other business interests.
Putting it all together – DCF method
A financial acquirer is paying today for a stream of future profits, which is why companies are generally bought and sold using a multiple of earnings.
But focusing on your multiple is a little like a hypertensive person focusing on their blood pressure. To move it up or down – you must understand the calculation.
The calculations behind your multiple
Buyers calculate what they are willing to pay today for the rights to a business´s future profits. For example, you might invest $1000 in a government bond offering five per cent interest per year; you “spend” $1000 on something worth $1050 a year later.
Imagine your company projects $1,000,000 in pre-tax profit next year. Buyers wanting 15 per cent return on their money in one year would pay $869,565 ($1,000,000 divided by 1.15) today for $1,000,000 a year from now.
Financial buyers not only value the next year´s profit, but all expected profits in the foreseeable future. For every year into the future, they will “discount” the projected profit by the expected rate of return.
In rare cases, a “strategic” sale may result in a higher multiple where an acquirer can leverage its own assets to grow the business much more quickly than its current owner.
The relationship between risk and return
The price (valuation) relates to how risky the future stream of profits is perceived to be: the riskier the investment, the higher the return an investor will demand.
Despite this, it’s important to understand you are not selling just the book value of the business, but also a vision for its future growth.
Kerry Boulton, Founder, The Exit Strategy Group and author of “Million Dollar Pay Day: How to Get Rich and Get Out…Creating the Perfect Exit Strategy and Life After Business”