This post originally appeared on OneAccordPartners.com and has been adapted for OneAccord Capital with permission.
Four times earnings, one times revenue, six times free cash flow—we’ve all heard these multiples, or rules of thumb, and may have used them as a benchmark at some point to determine a company’s value. Formal business valuations are conducted for a variety of tax and legal reasons, and the IRS and the courts have provided guidance and rulings for reference. But how do these formal valuation methodologies relate to the multiples we often use for placing value on privately held companies for transaction purposes?
Valuation methods rely on judgment and experience and can yield a wide range of conclusions based on the perceived risks and potential opportunities in each case. In other words, value is subjective. Extensive books, courses and careers have been dedicated to business valuation, but my intent is to provide a high-level overview of the factors that go into valuing privately held businesses for the purpose of facilitating a smooth transition of ownership down the road, regardless of the company’s current stage or direction.
We rely on multiples for valuations for a number of reasons:
- They’re fairly easy to calculate and understand.
- It’s easy to make comparisons to related companies.
- Data may not be available for a more detailed valuation.
- A formal valuation simply may not be worth the cost and effort since formal valuations can be complex, highly subjective and may not produce a better answer anyway, depending on the situation.
Multiples are shortcuts. Shortcuts are not necessarily bad, but it helps to understand their strengths and limitations. There are three frequently used methods for valuing private companies.
The asset approach is based on asset value, which is simply the market value of all assets minus the market value of all liabilities. Generally, this applies to companies with little to no profits or a low return on assets.
This second method is based on how much income the company generates. In other words, the value is derived from the risk-weighted return on investment that the company provides, just like most other financial investments.
The market approach relies on comparing a business to the known value of other, similar companies that have changed ownership in the recent past.
The income and market approaches are widely used methods for valuing profitable companies. Their strength is that they both incorporate fairly robust quantitative analysis and time-tested methodologies to calculate value. The drawback is that they both rely on assumptions, judgment and less-than-perfect information. Accuracy is more important than precision when it comes to business value, so the right multiple correctly applied can give as good or better an indication of value than a detailed discounted cash flow model with unrealistic projections.
Regardless of the method used, business fundamentals are always going to be central. Some of the most common value drivers include outlook for growth, margin strength, revenue diversification, management strength and depth, quality of financial statements and customer retention, to name just a few. Focus on what you can influence and realize that it takes time to build value. There are some things out of your control, such as the health of the overall economy, but you can increase value either by increasing revenue and profits or by decreasing perceived risk.
Value Early, Value Often
It’s generally a good idea to have your business valued early and updated annually, even if it’s just an informal valuation. Understanding value and value drivers will allow for a planned, smooth transition that will benefit all stakeholders (shareholders, employees, customers). Incorporate this into your broader goals so you can ultimately spend time and energy on the more important things in life.
Speak with an expert about transitioning your business.