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Keys to a Successful Business Valuation

Keys to a Successful Business Valuation

Lie Dharma | SmallBizLink

The hard thing about valuing a business lies in the great unknown of future cash flows and the risks associated with being able to generate future cash flows. While historical operations can provide a sound starting point to determine future cash flows, it can also be very misleading. For example: a biotechnology company in an early stage of clinical trials has no historical positive earnings or cash flows, but may hold an extremely high market valuation based on the promise of future cash flows from the eventual production and sales of a new drug. Or conversely, a cemetery operation may have a one-time event due to a liquidation of real estate holdings (held for a long time), which will be nonrecurring. Hence, future cash flows can be distorted by historical events that are nonrecurring (positive or negative). The key lies in the ability to calculate a core or operating cash flow figure on which to base the valuation.

Through this post I share some little tips and trick to uncover lies behind the shady—unknown of future cash flow I mentioned on the preface which is the key basis in determining the most appropriate business value. Read on…

Adjusting Cash Flows To Be Used As A Business Valuation Basis

The following points, by no means all inclusive, provide a flavor for how cash flows can be adjusted to be used as a basis when determining the most appropriate business value.

Expense savings – One company may be interested in acquiring a business that offers tremendous expense savings opportunities via implementing the concept of economies of scale. By combining the two entities, an unprofitable business now may actually produce a positive cash flow (which has value). The elimination of duplicate accounting functions, human resource tasks, distribution facilities, and so on are often cited in business acquisitions and can assist in supporting the valuation calculated for the business being acquired. Easy targets include duplicate business overhead functions, such as accounting and finance, because, generally speaking, two CFOs or even two accounting departments aren’t needed in the combined entity moving forward.

Added expense removal – Pushing through other or personal expenses in closely held businesses has been around as long as the IRS (actually longer). Generally, these expenses aren’t necessary for the ongoing business to operate, but the owners take advantage of the tax break. Removing these expenses to increase cash flows can lead to higher business valuations. Examples of these types of items include retaining family members in various administrative or clerical positions that are more of a luxury, inflating owner salaries, or passing through various personal expenses associated with travel, autos, and so on. Of course, nobody is questioning the legitimacy of these expenses for tax purposes, but I have yet to find a company that does not test these waters somewhat.

Potential cost increases – Certain companies may be at a stage where a significant reinvestment in capital equipment, assets, and so on is required to continue to support and generate cash flows. You need to factor in these one-time expenditures into a business valuation model to reflect the impact on future cash flows. While depreciation expense is added back to determine the proper EBITDA, this figure can also be reduced in the scenario where significant reinvestments in fixed assets are required to keep a company competitive, such as upgrading its facilities to meet new environmental regulations.

Hidden assets – Certain assets may have a significant value present external to the core business. For example, a company may have purchased real estate years ago for future business expansion, but the property is no longer needed internally. To an outside party, the value may be substantial, and, as such, this hidden value needs to be reflected in the complete business valuation. Or conversely, this asset may be excluded from the business valuation and carved out from any potential analysis to capture the core value of the business.

Intangible assets and/or intellectual property – Brand names, research in process, patents, trademarks, contracts for retail shelf space, and similar types of assets have the ability to generate significant cash flows if managed properly. While one company may struggle with generating adequate cash flows, another may prosper by applying its marketing or financial muscle to an intangible asset.

Lost future business – In service organizations, a business valuation may decrease as a result of a key principal leaving or retiring. Anyone who has evaluated an acquisition within the service industry knows how critical this issue can be in terms of negatively impacting future cash flows. If a partner of 30 years leaves, chances are a portion of his accounts will also leave, which in turn produces reduced future cash flow.

This list could go on and on. When a business is valued, all elements and facts of importance must be evaluated in terms of determining what is the most reasonable future cash flow stream that can be expected. From a logic standpoint, it’s relatively easy to understand why a seller of a business would want to maximize the cash flow stream, or EBITDA, because a higher valuation would be received. Conversely, it’s also just as easy to understand why a buyer of a business would want to minimize the cash flow stream or EBITDA because a lower valuation would be provided to the seller.

Factors Influence The Multiple-applied to The Cash Flow Stream

To increase the value of a business, a higher multiple applied to the cash flow or earnings stream is desired. Conversely, in order to decrease the value of a business, a lower multiple is used.

The following list, which isn’t meant to be all inclusive, covers factors that influence the multiple applied to the cash flow stream:

Interest rates – Interest rates, simply stated, represent the cost of capital. For our purposes, the most common reference point for interest rates is the prime rate as established by the country’s largest banks. In today’s relatively stable interest rate environment, you can expect reasonable cash flow multiples. However, when the Federal Reserve Board even mentions that rates may rise, it should come as no surprise that valuations may be pressured lower rates rise, business valuations decrease. This concept is based on the premise that the opportunity cost for the funds used to buy a business will be higher, and, with all things being equal (including the EBITDA of a business), the valuation must be lower to produce the desired return.

Growth potential – Higher growth opportunities translate into stronger future cash flow potential and demand higher multiples. Just ask the dotcoms of the late 1990s and early 2000s about how they received astronomical valuations based on the premise of extremely high future growth rates. From a business perspective, the more information, support, and data that you can provide a potential buyer about the growth prospects of your business, the higher business valuation you will receive.