Setting the Record Straight on Business Valuation
Many people can become incredibly confused about understanding what business valuation means. Many misnomers exist regarding the subject, which can be a complex financial discipline that consists of unintelligible jargon, reason and underlying mathematics to any outsider who may be looking to buy or sell.
Therefore, let’s reveal the truth behind a few myths of business valuation.
1.) Net income and net free cash flow are identical
First of all, there is nothing remotely similar to these two concepts. Net income includes a deduction for depreciation expense that many small businesses base on accelerated tax schedules. In addition, net income excludes debt service, financing proceeds, owner distributions, capital expenditures and changes in working capital.
Net free cash flow is more inclusive and relevant to value because it represents the amount of cash available to investors (equity and debt holders) in excess of the current operating needs of a business – the essence of value.
Therefore, a novice who substitutes net income for net free cash flow risks overvaluing the business because the former may disregard a company’s imminent need to update such things as equipment and the shareholder’s reluctance to reinvest in future operations. Net free cash flow takes into account capital expenditures and working capital requirements.
2.) Unprofitable companies have no value
Remember that fledgling businesses will possess value because they have potential to generate future cash flow, hard assets and internally generated intangibles such as patents, customer lists and proprietary software. Just because historically there may have not been profits in the past doesn’t mean there’s no value in a company that you may be looking to buy. For instance, startups and high-tech ventures my incur losses until they are up and running.
3.) If a competitor sold for 1.5 times revenues two years ago, a comparable business could do the same for a similar price-to-revenues multiple today
Nothing could be further from the truth in this instance. You may think comparable transactions provide objective, convenient evidence; but one, single transaction doesn’t provide a representative sample.
Remember that each transaction is unique. For example, a competitor’s sale might include buyer-specific collaboration like an earn-out or a seller’s employment contract. Ask yourself if the informant is reliable. Like an old wives tale, transaction details can become exaggerated and evolve over time as the story passes from one individual to another.
4.) Business value only matters when considering buying or selling
The granddaddy of all valuation myths, every business can benefit from studying the subject regularly, not once in a full moon.
Most owners have no clue what their business is worth from just an operational perspective. Therefore, having an informal valuation can teach management what drives value and show how to increase cash flow for both the short and long terms.
A valuation can shed light on economic conditions and industry trends that can help you improve operating efficiency and increase sales inevitably. It can be an integral part of contingency planning that can help management assess the adequacy of commercial and key person life insurance coverage as well as serve as an underpinning of effective buy-sell agreements, succession plans and individual wealth management planning.
— Peter King; CEO, VR Business Brokers
For assistance with Business Valuation please contact VR Business Brokers at 1-800-377-8722