In today’s competitive business environment, more than ever, is it important to know the value of your business today and focus your efforts on those activities that increase its value in the future. However, determining a businesses value can be a challenging task for some. In general, there are three key ways in which businesses are valued: liquidation value, market value and future cash flow value. Each of these valuation techniques has its strengths and weaknesses. The valuation technique or techniques used to value a particular business are based on such things as: business size, industry, and stage of business life-cycle.
Liquidation value is the total worth of a company’s physical assets when it goes out of business or if it were to go out of business. Liquidation value is determined by assets such as buildings, furniture and fixtures, equipment and inventory. Intangible assets are not included in a company’s liquidation value. Market value is generally the highest value of assets, though it could be lower than book value if the value of the assets has gone down in value due to market demand rather than business use. The book value is the value of the assets listed on the balance sheet. The balance sheet lists assets at their purchase price less accumulated depreciation, so the value of assets may be higher or lower than market prices. Finally, the salvage value is the value given to an asset at the end of its useful life; in other words, this is the scrap value.
Liquidation value is usually lower than book value but greater than salvage value. The assets continue to have value but, due to the limited time frame in which they must be sold, they are often sold at a loss to book value. Liquidation value does not include intangible assets. Intangible assets include a business’s intellectual property, goodwill, and brand recognition. However, if a company is sold rather than liquidated, both liquidation value and intangible assets are considered to determine the company’s going-concern value.
The Liquidation Value of a business can be very useful for a business that is going out of business. In these cases, a businesses assets are sold for cash relatively quickly and the proceeds from these asset sales are used to pay off the businesses liabilities. Any remaining cash would be the companies Liquidation Value. However, in most cases the Liquidation Value of a business results in the lowest value of the business, as it does not consider the future prospects of the business such as its ability to continue as an on-going concern and generate future cash flow.
The Market Value approach to business valuation is rooted in the economic principle of competition: that in a free market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers would not pay more for the business, and the sellers will not accept less, than the price of a comparable business enterprise. The buyers and sellers are assumed to be equally well informed and acting in their own interests to conclude a transaction. It is similar in many respects to the “comparable sales” method that is commonly used in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison. The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose. Also, for a private company, the equity is less liquid (in other words its stocks are less easy to buy or sell) than for a public company, its value is considered to be slightly lower than such a market-based valuation would give. For some private companies, valuation experts may look to other similar private companies that have recently sold in the marketplace. They will use various financial metrics such as multiples of prior years: annual revenue, annual earnings before interest, tax, depreciation and amortization “EBITDA”, or net cash flow, to value a similar business. They will apply these financial metrics to the financial performance of the business they are valuing. The advantage of these market based assessments, is that they do take into consideration current market conditions when valuing a business. Furthermore, they can be calculated relatively quickly. The disadvantage of these market based assessments, is that they may not take into consideration the historical trend of a business or the future opportunities of the business and as a result, the business valuation can be inaccurate. For example, consider two businesses, business A had increasing revenue over the last three years $100M, $200M, $300M, while business B had decreasing revenue over the past three years $500M, $400M, $300M. Using a market value approach to assess these businesses based on a multiple of prior years revenue, would result in the same valuation for these businesses. Which business would you rather buy?
Future Cash Flow Value
The Future Cash Flow Value approach relies upon the economic principle of expectation: the value of business is based on the expected economic benefit and level of risk associated with the investment. Future Cash Flow based valuation methods determine fair market value by dividing the benefit stream (i.e. future cash flow) generated by the subject company times a discount or capitalization rate. The discount or capitalization rate converts the stream of cash flow into a net present value. The result of a the value calculation under the Future Cash Flow value approach is generally the fair market value of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies. The advantage of the Future Cash Flow valuation technique is that it values the business as an on-going concern and takes into consideration the future prospects of the business. This valuation technique also takes into consideration the risk associated with the business with its use of the company’s weighted average cost of capital, which varies by business. The disadvantage of the Future Cash Flow Valuation technique is that it is based on a forecast of the future, which may or may not be accurate.
Assessing the Value of Your Business
As you can see from the above mentioned discussion, there are strengths and weaknesses to each of the three valuation techniques. The key is to understand where your business is today, what industry do you compete in? What is the size of your business relative to other competitors in your industry? At what stage of the business life-cycle is your company? Is your business a startup that is just entering the market? Have you been in business for a while and are reaching the peak of your business life-cycle and highest output? Is your business and industry declining in size and growth and at the end of the business life-cycle? Answers to these questions can have an impact on the business valuation technique that is most applicable to your business. In some cases, all three methods of valuation may be used to value a particular business. These valuations can then be used to triangulate on the true value of the business. As a business owner, the key is to be assessing the value of your business on a regular basis. Once you know the value, then you can develop business strategies to increase this value over time such as increasing revenue growth, improving profitability, liquidity and solvency and getting a greater return on investment. As they say, you can’t improve what you don’t measure! Measurement is the first step that leads to control and eventually to improvement. If you can’t measure something, you can’t understand it. If you can’t understand it, you can’t control it. If you can’t control it, you can’t improve it!
Don’t get surprised by your business valuation when your are looking to exit! It is in a business owners best interest to have their business valued on an annual basis. This way they can they have an accurate assessment of their current business value and they can work on creating more value over time. Furthermore, business owners can quickly modify their business strategy to accelerate this value creation. They can also position their business for a successful merger or acquisition at the highest business valuation!
If you have any questions regarding business valuations or would like to discuss your business value, please give us a call today at (480) 980-3977!
Paul J. Beckert MBA, CPA