The Transition Companies Recycling Blog

Business Valuations: Getting the Best Price

The Transition Companies is hereby providing information on valuing a business or business valuations for the purposes of a business sale. The Transition Companies can also provide the management consulting to increase earnings and optimize a company to increase its business enterprise value.

Valuation Methodologies

There are various methods of valuation. Within each method, different standards, characteristics, and premises of value apply depending on the valuation purpose and its context. In general, the three valuation approaches are: Discounted Cash Flow Method, Market Approach, and Asset Approach.

Discounted Cash Flow

Discounted Cash Flow is the most widely accepted professional valuation approach in the M&A arena and the approach used most by buyers. Under this approach, value is the sum of the future projected cash flows of the business, discounted back to the present value at the appropriate discount rate.
The difficulty here is determining the appropriate discount rate. The discount rate should reflect the risk of the business (and its likelihood of meeting cash flow projections) as well as estimates of return on investment (ROI) and cost of capital, current interest rates, and current and projected inflation rates.

In addition, premiums or discounts are applied for control and marketability of the business. Other qualitative factors taken into account include the company’s reliance on key individuals, limited product diversity, heavy reliance on one account or supplier, and a multitude of other factors, many of which are industry-specific or specific to the particular company. The Discounted Cash Flow method shows how much a buyer can pay based on their ROI expectations. The market approach (detailed below) indicates what a buyer will have to pay for the business in a competitive sale.

Market Approach

Under the market, or sales comparison approach, data is gathered on transactions of similar businesses for review of capitalization rates and multiples. If valid comparables are available, they need to be adjusted to reflect the difference in marketability. Two issues need to be considered:

1. Data on the sales of privately- held companies is limited. Often the owners of privately-held companies do not disclose the details of their private transactions.
2. No comparison can be made between the value of a privately-held company and a publicly traded one. Due to the “mass market” and liquidity options available, publicly traded companies “trade” at higher values than privately-held companies.

Asset Approach

Adjusted Net Book Value (adjusted for obvious overstatements and understatements), Replacement Cost (the cost of duplicating from scratch the company’s assets on an “as-if-new” basis), and Liquidation Value (the value of the company’s assets when converted to cash in short order) are all asset-based valuations. These valuations all result in very conservative estimates of the value of a business, based upon only its tangible assets. These methods do not consider the value of a company’s intangible assets, such as the company’s name and image, customer lists, internal systems and procedures, future opportunities, etc. The Asset Approach is not considered applicable to M&A unless the business is distressed.

A Note about Formulas and Rules of Thumb

Formulas and rules-of-thumb are usually based on a multiple of sales or earnings. These are informal valuations that pay little if any attention to the vast differences among individual companies. They generally have little or no basis in reality unless substantiated by one of the recognized methods of valuation.

Valuing a Business for Sale

Determining or predicting a fair market value is often more accurate if the evaluator has actual M&A market experience.

Valuing a business for sale requires a critical analysis of the history and future of the business. From a historical perspective, the company’s financials should be adjusted — or normalized — to show the true profit potential of the business.

Market research should cover the topics of: industry size, industry growth, competition and barriers to entry, alternative and substitute products, external trends affecting the industry and geographic influences. In addition, an assessment of the company including market share, customer acceptance, product superiority, and technological position should be made to determine revenue and profit potential. The level of M&A activity and condition of the capital markets at the time also impacts the value.

Some value enhancers that increase value are:

• Second tier management team in place
• Diverse customer base with no specific customer dependence
• Proprietary or patented technology; if not defensible market positions
• Historical track record of consistent earnings
• Growth in the economic sector or vertical market
• High barrier to entry into the market
• Some unique operational platform
• Critical mass of the business
• Velocity in the company’s industry.

Some risk factors that mitigate value are:

• Owner dependence
• Key person dependence
• Lack of Non-Competition Agreements for key people
• Customer concentration with a few key customers
• Commodity products or industries
• Supplier dependence
• Changing technologies.

Valuing a company or business is ultimately the rendering of an opinion by an individual(s). The opinion, like all opinions, is subjective and is as credible and accurate as the experience, background, credentials, and perspective of the party presenting the opinion. Several opinions of value can be issued by several sources each having the same set of information but each providing differing opinions of value. Who’s right and who’s wrong?

While overviews of several theories of valuing a company have been reviewed, the best method of identifying value is through the open market. Proper analysis and presentation of a company to the open market should result in a competitive situation whereby the value is ultimately determined by the open market. The open market is in fact the court of final opinion on the value of the business.

© 2009 The Transition Companies . All rights reserved.

Tags: The Transition Companies Business Valuations