What Drives a Business’s Value?
Understanding a business’s value is critical key for several reasons:
- Helps an owner prepare for a possible sale, merger, or acquisition
- Provides necessary insight for employee stock ownership plan (ESOP) trustees
- Benefits attorneys who work on behalf of the owner during a sale, merger, acquisition, or litigation
- Assists with estate and financial planning
The following outlines a over simplistic approach to business valuation.
You have heard the saying “cash is king”, well in the valuation world for most all operating companies, cash flow is king.
Buyers want to know what cash flow stream they are purchasing prior to any deal. Adjusting the earning stream for a potential buyer includes removing any special circumstances in place for the operation. For example, this could include excess owner compensation or perks, non-recurring and unusual items.
The starting point for cash flow is usually Earnings Before Interest, Taxes, Depreciation and Amortization (commonly known as EBITDA). This measure is typically adjusted for the above-mentioned items and plays a key role in valuation.
A multiple is applied to adjusted EBITDA or another cash flow measure to arrive at a value in certain business valuation methods. Depending on the cash flow stream used, certain adjustments may be needed to arrive at an equity value.
So how is a multiple selected? Typically, from public markets and/or private transactions of similar businesses and usually you will find a range of multiples in the industry. The appropriate multiple is selected by comparison of the company to a peer group for factors such as:
- Growth – how fast is the business growing? Can it continue to grow in the future?
- Sustainability – are revenue and cash flow recurring in nature?
- Profitability – how profitable is the business? How does the profitability compare to the industry?
- Customer concentration and attrition – does the business rely on one key customer? What is the customer attrition rate?
- Management/key employees – do key individuals drive the business? Will the company not perform as well without them on staff?
- Industry risk/regulation – if the industry is heavy regulated, how could this impact the business?
- Technology risk – is complex technology required to run the business? Does the business have any intellectual property and if so, is it properly protected?
- Balance sheet – are leverage and liquidity adequate?
Knowing these key considerations when determining value helps develop a realistic expectation of what a potential third-party buyer could be expected to pay.
The above mentioned provides an oversimplified approach to a very complex process.
Business valuation is not an exact science and as the business owner, it’s understandable to have an emotional and personal investment in your business that may not translate the same to a potential buyer. As a potential buyer, the financials only present part of the equation. Our dedicated and experienced team at Apple Growth Partners will work with you to remove subjective outliers to establish the business’s true value. Our staff will review your information and piece together the story, from bottom-line financials to key considerations not recorded on the financial statements. Contact me today to start the process.