4 times earnings, 1 times revenue, 6 times free cash flow – we’ve all heard these multiples, or rules of thumb, and maybe 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 the 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 in this blog series 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.
There are a variety of reasons that multiples are relied upon for valuations:
1) they’re fairly easy to calculate and understand,
2) It’s easy to make comparisons to related companies,
3) data may not be available to do a more detailed valuation, and
4) 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, but are shortcuts bad?
Not necessarily, but it helps to understand their strengths and limitations. Back in the day when I was a college summer intern at an Army Corps of Engineers construction project in New Mexico, the project manager once told me to walk around the project site with a tape measure and just measure things at random; that way, all the construction workers would figure I knew what I was doing. I’m not sure I elevated the status of summer interns with this tactic, but it sure made me look relevant. In some ways, using multiples as rules of thumb in valuation is a little like the tape measure - a great tool, but it helps to understand what the measurements mean.
There are three frequently used methods for valuing private companies.
The first, the asset approach, is – believe it or not - 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. The second method, the income approach, 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 third method, the market approach, relies on comparing a business to the known value of other, similar companies that have changed ownership in 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 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 that are 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 the perceived riskiness.
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 more important things in life.
In the next two blogs, I’m going to follow up with some details about the income and market approaches to valuation and show the connection to the multiples that are commonly used.
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