Everything you need to know about valuation…and why you should care
April 2, 2015
By JT Archer
Originally published in Focus Magazine
Many business owners assume they should only care about how much their business is worth if they’re looking to sell or are going through a difficult situation, such as a divorce or corporate break-up. Unfortunately, this is a shortsighted view that misses the bigger picture. Every single business owner should know how much their business is worth because it’s the only measure that takes into consideration where your company has been, where it is today, and most importantly, where it’s going.
It may be surprising, but in my opinion valuation is the single most important concept in finance and something that every business owner should know about. At the end of the day, each of us is in business to create value. Your company’s value capture nearly everything about your business in one, easy-to-understand number. Valuation has a reputation for being boring, abstract, and complex, and to be honest, that reputation tends to be true. But fear not, dear reader, I’ve boiled it down to make it easy for you to calculate your business’ value yourself.
We’ll start with a simple definition – valuation is the price that a reasonable person would pay to own the future cash flows of a business, less any debt owed, plus all cash on hand. There are a number of different ways to calculate the value of a business, but the two most common methods are the discounted cash flow and market multiple methods. Under the discounted cash flow method, or DCF for short, you try to estimate the business’ future cash flows and determine how much they’re worth today.
The important thing is that we now understand that when using the discounted cash flow method, the value of your business is based on two things:
1. The cash flows you think you’ll generate in the future
2. The reasonable rate of risk-adjusted return you require to earn on those cash flows.
Once you estimate the cash flows and determine an appropriate discount rate, you simply utilize the present value concept to calculate the value of the cash flows. Present value is the value of future cash flows discounted back to today. In other words, what would you pay today for a dollar that will be given to you one year from now? The farther out the cash flow, the more it is discounted because there’s more uncertainty related to it.
From there, you subtract all of the debt that you owe and add in any cash on hand to arrive at the value of the business. Another easier method to calculate the value of your business is called the market multiple method. With this method we don’t worry about projecting cash flows or figuring out what a reasonable rate of return might be. Instead, we look at businesses that have actually sold and compare the sales price to a metric in the business, such as revenue or earnings.
Let’s look at another simpler example:
Let’s say that you own a restaurant and you want to know how much it’s worth. You know that a similar restaurant in your city recently sold for $1 million dollars and had about $200,000 in earnings. The market multiple for this business is calculated by taking the sales price of $1 million and dividing it by earnings of $200,000. In this case, the multiple is five times the earnings. So, using this estimate, you’d multiply your earnings by five, subtract debt and add cash to figure out what your company may be worth.
Which approach is better?
There are benefits and drawbacks to both approaches. The discounted cash flow model, while complicated, does a great job of capturing the specific story of your business, and more importantly, the direction you think it’s headed. The problem is that it’s really hard to predict the future accurately. It’s even harder to figure out what a reasonable rate of return would be for your business.
The market multiple approach, on the other hand, does a pretty good job of estimating what people are actually paying when buying businesses. Unfortunately, it doesn’t take into account the specifics of your company, such as your unique cost structure, and isn’t forwardlooking.
Best practice is to use both and weigh them according to how confident you are in each. That way you get the best of both worlds and can arrive at a reasonable value for your business.
Obviously, if you are selling your business, valuation is extremely important. However, valuation can and should be used as a powerful driver of how you manage your business. The purpose of this estimated value is to track the effectiveness of your strategic decision-making process and to provide you with the ability to track performance in terms of estimated change in value, not just in revenue. Valuation helps you recognize the benefits of taking a holistic look at your business and also helps you make decisions that highly impact your bottom line. It allows you to understand the subtle dynamics of your business and avoid unforeseen consequences of seemingly reasonable decisions. A value-based management approach will set you apart from your competition and dramatically change the way you, and the market, view your company.
If you’re interested in the value of your company today and what you’re company may be worth in the future, sign up for SBAM Pulse. Pulse will show you the current value of your company, as well as the benefits associated with greater financial performance.
JT Archer is the Chief Operating Officer for BodeTree, located in Denver, Colorado, where he heads up multiple aspects of the business including revenue growth, partnerships and capital solutions for customers. JT has 17 years of experience working with companies ranging from the Fortune 50 to the Fortune 5 Million. Prior to joining BodeTree, JT was President of PSO Global, a global energy efficiency company, co-founded Idaptic, a software productivity tool and held numerous executive positions at Level(3) Communications including head of sales, operations and varying engineering capacities. While in charge of operations, he led a team of more than 650 people responsible for a four billion dollar revenue stream. JT earned his Masters degree from the University of Colorado and his undergraduate degree from Metro State University.