There are entire books, courses, consultancies dedicated to valuing businesses. Yet, in spite of these there is very little credibility to those valuations with it being difficult to assign a fixed value to even large stable companies. A business is ultimately valued based on the same principles as anything else, based on supply and demand meaning in theory it’s worth what someone is willing to pay for it and so the question often becomes “what’s the normal level someone would be willing to pay for it? And how do you figure that out?” There are industry norms, small businesses depending on the industry, size, and assets tend to be valued at a 3 times multiple of earnings, a small accounting firm might be 75% of one year profits, sometimes various discount formulas are used. Large public companies tend to start around 10 times earnings and then vary depending on trends, assets, industry, etc. but these are very arbitrary and generic assessments, the type that are likely to get you into trouble. What’s the trouble? Why the inconsistency?
A business is valued essentially from one perspective only, ROI. In other words when considering what to pay for a business, what the business is worth the question is what will the return be for the investment relative to other opportunities? Though it’s generally not on the mind of most investors, entrepreneurs, and business owners, the basic comparison to be made is government or equivalent bonds. In other words government bonds tend to be a very certain, nearly as certain as you’ll get (assuming here we’re talking about AAA bonds) return. A similar retail comparison would be lending money on an insured mortgage or loan to value first position mortgage where the security is virtually absolute and will cover the potential losses. Understandably, a business is expected to produce a substantially higher rate of return than such bonds, why? Because there’s substantially more risk. In other words the balance being struck is the perceived risk relative to the apparent return, this is where we start to see the difference between the returns offered in a small business vs. a large public company. In a small company it tends to be less stable and thus uncertain, in a large public company there’s generally an established infrastructure, brand, system, etc. and thus greater consistency in the long term performance, though neither generalization is accurate. In a sense you might say purchasing at a 3 times multiplier (a theoretical 33% return) vs. say a 3% return on government bonds is a statement that “The risk of the business is 11 times greater than that of the bonds” (it’s not quite that simple but it communicates the general idea).
There’s an added complexity when it comes to a business that isn’t present in most other purchases such as real estate, bonds, or commodities. The value of anything is contextual, meaning it is worth different amounts to different people in different times and places, however, nowhere is this more profound than with a business. Think about Microsoft acquiring Skype for $8 billion. Was it worth it? Debatable, but how could it possibly be worth it when Skype wasn’t producing any profit? The answer lies in Microsoft’s ability to use what Skype had (something like 160 million users) to extract more value than Skype could alone. How? Being able to sell other Microsoft products to them for a start. Or the ability to decrease development and marketing costs associated with trying to capture that same market share from Skype. Or the ability to keep competitors such as Google or Apple out (at the time of the acquisition Apple was driving forward aggressively with Facetime and the only real mobile competitor product was Skype). This concept of leveraging an asset within the context of another company to be worth far more than it is worth outside that company is the root of most acquisitions that occur at outrageous multipliers (the other is the value of durability in dominating a market space).
On the one hand you have the uncertainty of the business’ future performance, which is often almost complete speculation. (I was involved in the sales process of one of my companies recently and remarked at how ridiculous the idea of using multipliers as a means of valuation was given the fact that in a business such as this one revenues and profits could easily double or be reduced by half after a change of ownership or management and consequently it was laughable to look at the scenario as though there was some kind of predictable return in the future). On the other hand you have the context of what it’s worth to the buyer and the market, which can vary wildly. The combination of these factors make valuing businesses in general to be a virtually impossible feat.
Where then does this leave us?
Warren Buffett offers what is perhaps the most profound insight into business valuation. Essentially, his position is you can’t accurately value most businesses; there is simply too much uncertainty at least as an outside investor. Instead, you need to focus on businesses that are like bonds or cashflowing real estate; they have a stable long term outlook. These he defines as businesses with a “durable competitive advantage”. Such an advantage is often difficult to quantify and might come in many forms depending on the scale of the company, but it must have some advantage that’s extremely difficult to crack, sufficiently so that the costs don’t make it worth the returns and consequently the business is likely to endure for an extended period of time or perhaps even grow. If a business is consistent and stable you can assign a valuation to it and those valuations should be directly comparable to the rate of return of bonds.
The other case where business valuations are possible with a certain accuracy is when there’s a current asset whether tangible or intangible that will have an immediate value for the business making the acquisition. This might be a customer base, it might be technology, or might be infrastructure, a brand, or a team. In each of these cases a calculation can be made based on how valuable they’ll be to the new owners within a margin of error and make a decision accordingly.
Beware anytime someone comes to you with a fool proof method of business valuation, it can be dangerous but because it is so challenging it is also perhaps the greatest opportunity for market inefficiencies.
To learn more about buying businesses, business valuations, investing, business growth and wealth building follow our articles and information or contact us with any questions you might have to receive personalized answers.
https://richucation.com/wp-content/uploads/2015/06/evaluation.jpg6001000Michael B Rosmerhttps://richucation.com/wp-content/uploads/2016/01/richucation-1.pngMichael B Rosmer2015-06-07 09:54:522016-01-16 12:27:38Why is business valuation so hard?
Looking for business consulting?
Richucation helps a handful of clients to maximize business growth each year, click here to see if the next business is yours!