There are several ways that a business’ value is determined. But before describing them, it is important to point out that the value of your business is largely determined by the industry in which you operate. For example, when I first got out of school, I ran a chain of coin laundromats. Whether it’s right or wrong, from a valuation perspective, laundromats tend to be worth some multiple of sales or profits. When selling this company, I could have shown the buyer the value of the businesses, as calculated by discounted cash flow (DCF), but it wouldn’t have affected the price someone would have paid me at all. They were looking to buy it at two or three times sales. Yes, it’s important to know how to calculate the value of your business, but it’s almost as important to understand the heuristics–rules of thumb–that apply when valuing a business in your industry.
Before embarking on describing the various methods for valuing businesses, I have to point out that the discounted cash flow method is the best method for valuing any asset, and I will explain why. One of my favorite shows on TV is Pawn Stars. If you’re not familiar with the show, it is about a pawn shop in Las Vegas, and it shows the various interactions and transactions between the owners of the store and the people who come in to sell things. It’s always interesting to me to note how few people know the value of the items they are selling. In a way, they are negotiating based on air, since they have no point of reference on value. DCF is the best methodology because it calculates the “intrinsic value of a business” and gives you a strong point of reference.
It’s probably beyond the scope of this piece to explain DCF in great detail, but you essentially derive the value of the business by forecasting the future positive cash flow that the business will generate against the rate of return you seek for the risk that the business represents. If you think about it, the value of any asset is the cash that asset will generate for you and the targeted rate of return you will receive. For example, suppose you run a business that generates $200,000 a year in positive cash flow and that the business’s cash flow is growing at five percent a year. Let’s assume that you, as the owner, are interested in buying your business again as an outsider–put yourself in the position of an outside party evaluating the risk of your business. Let’s say that you desire a rate of return on your business of 15 percent (the discount rate). If you valued this business using these metrics with a forecasted period of 5 years, the business is worth $2 million. This means that if you paid $2 million full cash for the business and your forecast is accurate, you would receive a 15 percent rate of return on your investment. Most importantly, you know the intrinsic value of the business before you put it on the market. This does not mean you will get what the business is intrinsically worth, but at least you’ll know what that intrinsic value is.
People use other techniques to value businesses, such as the asset-based approach, through which you look at the value of the assets of the business and basically adjust the company’s balance sheet to reflect the value of those assets. Other businesses are valued based upon the “book value” of the business, which equals assets minus liabilities. Many accountants erroneously and extraordinarily use book value to value a business, but this methodology is rarely appropriate.
Finally, it has been my experience, for good or for ill, that most businesses are valued using simple rules of thumb that are accepted within the industry, regardless of whether or not they make sense financially. For example, accounting firms are generally valued at one time annual revenue. Coin laundromats are valued at two to three times their annual profit. Software companies can be valued at three to five times their annual revenue. Physicians’ offices are valued at between one and 1.25 times annual revenue. Banks are typically valued at around 18 to 25 times earnings. Since heuristics seem to govern the value of businesses, it’s crucial to know what rule of thumb applies to your industry. Clearly, these shortcut rules are not hard rules and should be adjusted for important items, such as whether the business is growing, how profitable the business is, how strong its margins are and many other intangibles such as strength of the employee base and the product or service.
A business is worth what someone will pay for it. However, when all else fails, the real value of a business is its future cash flow, so long live DCF! If you don’t believe me, read about Warren Buffet’s investment philosophy, since he is a lot smarter than I am anyway. And if you’re not comfortable making this judgement call on your own, be sure to talk to your accountant about the topic. They have a great wealth of experience and expertise that, in most cases, they’ll be happy to share with you. All you have to do is ask.