Just recently, a dear friend of mine was asking how he could value a certain business he had, so that he could justify the price to a potential investor. Of course, many people would simply price it based on a whim or whatever the customer is willing to pay for, much like in a flea market. While the general impression in bargain markets may be that prices tend to be against the unsuspecting buyer, there have been a number of cases where the buyer had the last laugh when the seller let go of an unknown rare or other extremely valuable object for a song.
From a more scientific perspective, among the ones I like the best in terms of business valuation are based on the cash flow, asset valuation and replacement value. I find that all three have a logical basis to it and is quite easy to understand even for those people without a finance background. Sometimes all three are determined and a middle ground in terms of valuation is selected. Of course, the answers could vary greatly depending on the assumptions made.
The key would be to be able to justify your assumptions.
In the cash-flow method, all the future cash inflows of the business is determined, typically on an annual basis. All these net future cash flows are brought back to the present time by discounting it with the cost of money to arrive at the net present value.
The net present value represents the value of the business and the discount rate is the rate of return of the investor. Typically, because of the time value of money, where the value of something becomes less and less as it moves into the future, you would not need to calculate all the future cash flows for the next hundred years. Often the cash flows are only calculated for the next 10 or 20 years, and then a fixed cash flow is assumed into perpetuity.
Asset valuation is assigning a market value to all of the assets of the business as if it is going out of business and anything that can be liquidated is sold. Not necessarily the best way to get the most value out of your business, but it does have applications. For example, a real-estate company is into rental properties. If these rental properties were acquired a long time ago and the property prices have appreciated dramatically, chances are a higher business value can be achieved using the asset-valuation model as compared to the cash-flow method.
The third method I also like is the replacement value.
The easiest way to explain this is how much would it cost to replicate whatever the business currently has and is doing. If the business produces and sells steel pipes, this would include the cost of the factory, setting up the sales force, the cost of building up the brand, distribution system and customer base.
Part of the valuation would also include the time it would take to build the factory and bring the level of sales to its current level.
This has the elements of a market value and the time value of money. This would be very justifiable for investors that want your business but do not have the time to wait to build it up from scratch.
Whatever method you choose will only serve as the starting point of negotiations. Assumptions on growth rates of the business, market values, goodwill and many others will be subject to both scrutiny and discussions. It is also possible that different investors may have a different view of the company they plan to invest in, depending on a variety of factors, such as synergy, strategic importance, market presence and the resources of the company.
Therefore, it may not be a bad idea to consider other options when faced with certain opportunities.
These are only a few methods of how certain businesses are being valued. Certainly, there are many other ways to value specific businesses.
However, at the end of the day, choose the one that gives you the best valuation, but then again, I remember one of the best bosses I ever had once told me that the best time to sell is…when there is a buyer.
Comments may be sent to georgechuaph@yahoo.com.