Business valuation might seem like a black art, but it's not that hard when you understand the concepts behind what gives a business its value. In this video we distill the field of business valuation down to its core principles, and provide a practical system for how to approach the valuation of a small business.
What Is A Business Worth?
The value of a business is the sum of its future cash flows. That’s all. If a business is (in value terms) just a machine that makes profits for its owner, then a fair price to pay for it would be exactly equal to the sum total of the profits and losses it will make in future.
Discounted Cash Flow
Now, we can calculate this figure by making thousands of assumptions to literally forecast the profits and losses of the business each year into the future, and then discounting them at an interest rate to allow for the time value of money – this is the Discounted Cash Flow method. It is a very direct approach, but its accuracy rests on the accuracy of all of the assumptions that it is built on.
Valuation = Sum of Future Cash Flows
Once we know the value of a business, the next thing to calculate is the payback period on an investment into this business. In other words, if an investor was to buy the company for an exactly fair price, how many years’ future earnings would it take to pay back this investment? Since the payback period shows how many years’ earnings are represented by the value of the business (or the “price” of the business in the case of public companies), then it is effectively the ratio of the company’s price to its earnings: the PE Ratio. This is also called the PE Multiple, since it shows what multiple of earnings is represented by the price.
The payback period is really an indication of how confident investors are in the future potential of the businesses. If investors don’t have a lot of confidence in a company, they will demand that their investment is returned quickly – a short payback period – whereas the opposite is true for businesses that they have more confidence in.
PE Multiple Method
Now, very similar businesses would be expected to have very similar payback periods, since investors would weigh them equally. For this reason, we can use the payback periods (or PE Multiples) of businesses where we know these figures, to provide an indication as to the PE Multiples of other similar businesses.
This is the principle of the PE Multiple approach to business valuation. Instead of making thousands of assumptions in order to calculate the future cash flows of the business, and add these up to derive a valuation, we can instead make just one assumption regarding the PE Multiple, which incorporates all of the other assumptions by showing the payback period on the investment. Once we have the PE Multiple we can multiply this by one year’s earnings to calculate the valuation.
Valuation = Earnings x PE Multiple
The crux of the PE Multiple method is how to choose the multiple of course. There are some basic guiding principles involved: for example, a company’s size is the most important factor, followed by its industry. In addition to basic theoretical principles, we can use real-world comparable data – sales prices and PE Multiples of other similar businesses – to provide more evidence. Our next blog post and video will be on comparables. Finally, in some industries there are specific “Rules of Thumb” that are used to define the multiple that should be applied to calculate the valuation. We will come back to Rules of Thumb in the fourth video in this series.
All of these factors together will provide a guide to the range in which the PE Multiple will sit. Exactly where in this range is dependent on the quality of the business itself: for example, whether it has management in place or is dependent on its owner; how stable it is (the presence of long-term contracts, for example); how much growth is forecast for the business and the industry in future. These details, while not as significant as the size of the business in determining the PE multiple, will for smaller businesses often determine whether the business sells at all. Finally, it is important to remember that the inherent value of the business is not the only factor that determines its sale price (and terms). Negotiation will be driven in large part by how well the sale process is handled: especially how many willing buyers are found who are willing to bid against each other to make the acquisition.
Finally, there is one caveat to the principle that “a business is worth the sum of its future cash flows”: this only applies if this figure is greater than the value of the net assets of the business.
For businesses where the total future cash flows (based on realistic assumptions) is less than the value of the net assets, then the net asset value that will determine the valuation. This situation can arise when a business is unprofitable, or when it is “only just” profitable, and the asset value outweighs the valuation given by forecasting the total future profits. Very small businesses are frequently in this situation, but sometimes larger businesses that are very capital-intensive can also be in this position. The sale of a business like this is effectively an asset sale, so an Asset Valuation will be appropriate. We will discuss asset valuations and asset sales in the fifth blog post and video in this series.
Three Methods, One Principle
In summary, a business is worth the sum of its future cash flows (as long as this amount exceeds the value of its net assets). This number can be calculated by making many assumptions that allow us to forecast and add up all of the future cash flows using the Discounted Cash Flow method. Or we can reach this valuation by making one assumption regarding the payback period required on the investment, based on similar businesses, using the PE Multiple method. For cases where the net asset value exceeds the value of the future cash flows, the sale of the business will effectively be an asset sale, so an asset valuation will be the appropriate method.
In our next video we will look at some available sources of industry comparable data, including some hard numbers for businesses of various sizes in various industries.