Value – The First Variable in Your Selling Equation
By Brian Goodhart
Value is the first variable in your selling equation and for good reason – it is the one talked about the most and the metric by which most people determine the success or failure of a deal. In order to adequately discuss value, it is first necessary to understand how value is determined and what theoretical valuation approaches have to do with the practical realities of closing deals.
Valuations come in many forms and there are a number of approaches to arriving at a company’s value. The following list is neither all-inclusive or exhaustive. Most analysts use a combination of methods when determining value so it helps to be familiar with some of the basic approaches when contemplating a transaction.
The first approach to valuation is the Asset Approach. This approach is conceptually the simplest as it examines the assets of a business and attempts to answer the following question: What would it cost to replace all of the income generating assets required to operate this business? While conceptually simple, the practice of using this approach is anything but. Modern businesses often don’t have many assets in the strictest sense of the word. When we examine their balance sheets, we see computer equipment, but not the valuable data they store. We find property, plant, and equipment, but not the company’s location on the internet and its organic search ranking. We see payables from customers, but not the long relationship and reputation that fostered those sales. The asset approach and the assets on the balance sheet are simply inadequate in some cases to accurately capture the value creating assets actually employed by a business. This is not true in every case, but it is true often enough that one needs to approach this method with copious amounts of caution. One of the few times when this method is preferred would be surrounding a business liquidation. In that situation the asset approach may be the most realistic method.
The second approach commonly used in valuations is the Market or Comparable Firm Approach. This approach is akin to the method used to value real estate where an appraiser attempts to ascertain the value of one piece of property by examining similar transactions that have previously occurred in the market. Since companies are more complex than real estate, a valuation professional usually looks at the valuation metrics applied for closed or public transactions and applies them to the subject firm. A key advantage of this approach is that it is not theoretical. The research uses the results of actual transactions. There is nothing esoteric or hypothetical about any of this. This approach uses actual data compiled from actual transactions. For example, the professional may examine a half dozen historical transactions and discover that the average valuation for similar firms is 3.0x sales or 7x EBITDA. They would then apply these metrics to the subject firm and get an approximation of the firm’s value.
As with all valuation methods, potential problems abound here as well. The first potential problem is that this approach is by definition backward-looking. It tells us what the market “did” pay for a comparable firm, not what the market “is” paying or “will” pay for such a firm. Another potential problem is that the value, EBITDA and Sales figures reported may not be accurate for private companies. A third potential problem is the definition of the word “comparable”. Are these firms truly comparable to the one in question? With private firms it can sometimes be quite difficult to know how much of their business line is one product or service versus another. Still another potential problem is that sometimes we must use public company data and then discount the results because the subject company is private. To account for this variability, valuation professionals will lean into the comparables they feel are closest and most accurate and discount or remove entirely those that seem unrealistic.
The third and final approach that I’ll discuss is the Discounted Cash Flow (“DCF”) Approach. This method is one that removes the market from the analysis and instead examines a business in its purest form – as a cash flow producing entity. In order to do this it forecasts the firm’s cash flows out into the future and then discounts them back to today at an appropriate discount rate to arrive at a present value for said cash flows. A company, like any other asset, is worth the sum of its future discounted free cash flows.
The DCF Approach has its own share of drawbacks as well however. The two key criticism often levied against this method are that it relies heavily upon future cash flow forecasts and that it involves calculating a discount rate which adequately captures the risk of those cash flows. Slight variations in either of these variables will produce very large changes in value.
So given the three imperfect methods discussed, how does one use this information to arrive at a valuation? Here is where the art of valuation comes into play. An experienced valuation professional will take the information provided by all three approaches and weight them based upon their assessment of the merits of each one in order to arrive at a single valuation figure (sometimes expressed with some degree of confidence using a range of values).
Now what? Now that you have a valuation completed by a qualified professional this should be all you need right? Can’t you simply take this number and show it to interested parties and have them send you a check? Not exactly. Buyers are not just interested in what a business is worth, they’re interested in what a business is worth to them. This is a complete separate calculation done by the buyer that will strongly influence their offer. Having a good, well-researched valuation prepared by a qualified professional should give the seller some sense of perspective and it should serve as a good tool for the buyer as they begin their own valuation and due diligence.
Now that we have one variable determined, it’s time to start on another.
Brian Goodhart is Capstone’s Director of M&A Advisory Services. If you would like to speak with him about the process of selling a business, please email bgoodhart@capstonestrategic.com
