Fundamentals of business valuation

(Sponsor post authored by Josh Weiss, CPA.) The value of a business is not something that you can look up or easily identify. The primary reason is that value is truly in the eye of the beholder. A business is effectively worth what someone is willing to pay for it. Not unlike many consumer goods,…

Sponsor: Thanks to Mastercraft Advisors, a consortium of four service providers, for supporting Silicon Prairie News. The group will be providing posts each month throughout 2013.

About the author: Josh Weiss, CPA, is an audit partner with Lutz and Company, PC, a member firm of Mastercraft Advisors.

 

The value of a business is not something that you can look up or easily identify. The primary reason is that value is truly in the eye of the beholder. A business is effectively worth what someone is willing to pay for it. Not unlike many consumer goods, the market often dictates the price of a product or a business. However, pricing one product is much different than pricing all of the hard work, goodwill, blood, sweat and tears that go into the value of a business.

Business values come in many shapes and sizes. The reason for that is because valuations are needed for many different reasons or purposes. A valuation might be for the outright sale of a company, to value stock options that might be granted to employees, to obtain financing from a bank or other financing institution, or for the always exciting accounting and financial reporting requirements. Valuation shows up every day. The stock market is nothing but valuation. It is a marketplace in which market participants decide on the share price of a company. Often those prices are over or undervalued, but only priced at what the market decides. This is why Facebook has an initial offering price at one level and it may drop below or go way above that level.

So if your company is not traded on a stock exchange or in a market where transactions happen regularly, how do you determine what is it worth? You have to ask the right questions to determine how to value the company. We typically value a company at fair market value, which is a hypothetical situation between a buyer and seller. That is very different from an investment value. An investment value is a strategic value. Someone wants to buy the company or a share of the company because it will make their existing company or portfolio better. The strategic buyer can offer not only money to buy it, but also expertise to help grow the target company. That strategic buyer might be willing to pay a premium for the target because they see the long term potential and are confident that their return on the investment will grow.

Valuation is forward looking. A company is worth what it can generate in terms of economic benefit in the future. What does economic benefit mean? Economic benefit is cash flow to the investor. So if I give you $100,000, how much cash flow back to me is that investment going to generate? A private equity fund or venture capitalist is looking to help companies grow and generate returns above and beyond what the company might with traditional financing or start up funding. So the value an investment buyer places on the company is different from fair market value.

In order to create value at a fundamental level, the company must demonstrate the ability to provide the future economic benefit. A buyer of that company is taking a risk. That risk is quantified in the rate of return they expect. This is often referred to as the cost of capital, which means I am going to give you my money with the risk that it may never come back or it may come back with some expected level of benefit on top of it. Often you hear that a company is valued at a multiple. The multiple is the measure of risk. A lower multiple shows that there is more risk in investing my capital in your company rather than putting it somewhere else. A higher multiple indicates that the risk is lower and as a buyer, I am more assured that your company is going to deliver the returns I expect.

Once that multiple is applied to the future economic benefit, that is the indication of value of the company. However, it is important to use the correct future economic benefit stream. Some measure of the cash flow will likely be the stream. The one most often heard is Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). EBITDA is a good measure because it shows what cash is truly available. However, that is only one benefit stream. For a particular company it may be net income or revenue. If you apply the same multiple to each of these benefit streams, you will arrive at three different answers.

Ultimately, every company is different and unique. The company is worth something in the eyes of someone. It depends on whom that someone might be. The motivations of the buyer and the seller are different. So take the time to understand the purpose of the valuation and take care to ask the right questions.

This blog post has been authored by our sponsor, Mastercraft Advisors. 


About the author: Josh Weiss is an audit partner with Lutz and Company, PC. He provides assurance, accounting and consulting services to privately held companies. He specializes in the construction industry. He is also a member of the Lutz business valuation team and is accredited in business valuation. Weiss has been with Lutz for more than seven years and has previous national accounting firm experience.  

About our sponsor: Mastercraft Advisors combines expertise in the critical business areas of legal, banking, accounting and IT tailored to meet the needs of startups and entrepreneurs. Four established and respected organizations—Advent IP, First National Bank, Koley Jessen and Lutz—have come together in Omaha’s Mastercraft building to bridge the gap between startups and service providers and better serve this important segment of the business community.

This story is part of the AIM Archive

This story is part of the AIM Institute Archive on Silicon Prairie News. AIM gifted SPN to the Nebraska Journalism Trust in January 2023. Learn more about SPN’s origin »

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