Building Value is a Process–Part Three

Under the Income Approach to valuation, maximizing value becomes a function of increasing net cash flow , decreasing an investor’s perception of risk or a combination of both.  Last month we discussed various ways to increase net flow and this month we’ll review various ways to reduce investor’s risk.  In valuation terms, investor’s risk is also referred to as an investor’s required rate of return or, capitalization rate, and it is expressed as a percentage.

A key component in determining the value of a going concern is the strength and transferability of the business’ cash flow.  An investor is likely to pay more for a cash flow that’s predictable than one that is subject to various internal and/or external sources of risk. 

The general rule of thumb is “the lower the risk the higher the value.” 

Below is a sample of some of the factors we commonly consider when evaluating the strength and transferability of cash flow.       

·         Company operating history and volatility of cash flow

·         Depth and quality of management

·         Competition and barriers to entry

·         Access to capital resources

·         Reliance on key person(s)

·         Size and geographic diversification

·         Concentration in customer base

·         Market resources in light of competition

·         Purchasing power and other economies of scale

·         Product and market development resources

·         Technological obsolescence

·         Reliance on vendors

·         Distribution system

·         Financial reporting and controls

·         Long term contracts with customers or unique products or

            market niche

·         Patents, copyrights, franchise rights, proprietary products

·         Operating facilities and capital investment needs

·         Industry and economic conditions

Broadly speaking, capitalization rates range from 17% at the low risk end of the spectrum to over 30% at the high end of the spectrum.  

By working with management, Stevenson Valuation Group has, over time, assisted management in increasing value by enhancing the quality of the company’s cash flow.

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The Importance of Valuing Your Business

Dear Clients and Colleagues:

The following article was written by Steve Parrish of Forbes Magazine, August 14, 2012 edition. I think you’ll find it interesting and enjoyable.

Sincerely,

Thomas G Stevenson, CPA, CVA

“““““““““““““““

IF YOU VALUE YOUR BUSINESS,

YOU SHOULD VALUE YOUR BUSINESS

At this year’s Berkshire Hathaway annual meeting, Warren Buffett made a key point all business owners should pay attention to:

“If business schools could offer just one course, it would not be on stock trading, the efficient market hypothesis or modern portfolio theory. Rather, B-schools should be encouraging students to learn the boring, but critically important, discipline of business valuation.”

If you already own a business, why would you need this skill? You’d need it only if any of the following apply:

  •  You may someday retire, sell, or leave your business.
  • You might die or become disabled.
  • You have key employees or partners whom you’re trying to motivate to be more efficient, productive or otherwise profitable.
  • Creditors, predators, or soon-to-be ex-spouses may someday want a piece of your business.

If none of these applies, carry on with your business … after you seek psychological counseling. If some of these do apply, however, consider having your business valued. And, as the Oracle of Omaha stated, learn something about the process yourself. Just because your lawyer drafts your will doesn’t mean you shouldn’t know something about wills, and even though your accountant does your books, you still need to understand financial principles. The same applies to the valuing of your firm. Business valuation is a process done by professionals, but it’s a product the business owner needs to understand.

Valuing a privately held business can be complex, but the overall process can be simply explained. A standard — what I’ll call “baseline” — business valuation seeks to address three basic questions:

What is the value of the business’s assets?

  1. What is the value to an outside party of the firm’s ongoing business (for example: revenues, profits or brand)?
  2. What does the current market look like for similar businesses (comparable sales, what banks are lending on, etc.)?

A business valuation is an amalgam of answers to the above questions. And the valuation will typically be unique to each business, sector and industry.  Consider three simple examples: a farm, a dental practice, and an online retailer.

With a farm, the assets are a primary consideration. How many acres, what farm machinery is in the operation, and what loans are there? Because the end product — the crop — is a commodity, differentiation between one farm and another is difficult to achieve. So a valuation would look at the hard assets, see what other acreage in the area is selling for, and from these answers, a baseline valuation could be created.

A dental practice involves a combination of earnings and assets intrinsic in the valuation. The practice includes hard assets like chairs and x-ray machines, but it also has a customer base that religiously returns every six months for a cleaning. So a valuation would hone in on the historical profit of the practice and try to project forward how large and loyal the customer base is. The valuation would seek to answer the question: how many months or years of profits could a purchasing dental firm expect to yield from the practice? A look at comparable dental practices in the geographic region would help further refine the process. Add in the value of the hard assets, and — voila! — you have a baseline valuation.

The valuation of an online retailer may be more challenging, but manageable.  Beyond any inventory the retailer owns, the hard assets may be few.  But there are likely two other asset types that need to be considered. One is the kind that goes home at night: the employees who buy, market, and service the accounts. The other asset is the online brand the company has created.

Would an independent buyer find value in leveraging the business’s online presence and reputation?  Finding comparable businesses that sell in cyberspace offers fewer historical examples than farms or dental practices, but a positive feature is that the value of an online business is less likely to be geographically affected. The baseline valuation for an online retailer will probably include the inventory and a capitalization of earnings, revenues, and whatever other key metric is used to value such a business. For example, the business’s growth trend is likely to be a key measure in this kind of industry.

Taking this baseline valuation and massaging it to recognize the unique features of the business, the reason for the valuation, and the timing may that apply is a topic for future articles. But the message is still simple: A business owner should have the business valued, and should understand the principles of the valuation. It seems to have worked well for Warren.