What Factors Determine the Value of a Business?
Understanding the Business Valuation Equation
Steve Mize, ASA, January 6, 2021
GCF was engaged to value a pharmacy and the lender quickly explained how “strong” the deal was even stating: “This is a slam dunk!” So, we began the due diligence process and immediately discovered:
If there’s a conversation underway about requesting a business valuation, the underlying question will always be around what exactly determines value.
Most business owners, lenders, and other financial professionals understand that while there is a set of common, non-negotiable factors that goes into the valuation equation, other factors (and the weight assigned to them) will vary by industry, business structure, and other individual characteristics of the business under review.
Common assumptions around value include emphasis on physical assets, track record for financial performance, trademarks, patents or even significant, long-term customer relationships. Of course each of these factors does contribute to total value, but often not as much some would expect.
Cash Flow Rules
The indisputable king of a business valuation is cash flow. As every business owner knows, sales are just sales until they deliver a profit – ideally in a timely and repeatable fashion.
So while a business valuation professional will always study and consider the business’ total financial picture as revealed by its financial statements, the business appraiser is ultimately looking for a reliable pattern of positive cash flow to anchor the value of a business. When there’s a solid picture in place for cash flow, every other aspect of the financial statements is more dependable, and the business is in a strong position to support maximum value.
Factoring Business Risk Into Valuation
Cash flow is king, but then there’s risk. Always. So the next question is how much risk? And what are the cash flow implications of that risk?
Risk presents itself in many forms, and the experienced business valuation professional looks at each one to come up with an assessment of total risk facing the business, both long-term and short-term. Short-term risk might include a situation where the business is overly reliant on one or two customers for a substantial portion of its cash flow – what’s the trajectory if one of those customers cuts back or goes away altogether? Other businesses face risk built in by seasonality and weather, and still others are subject to changes in trade policy or supply chain risk.
Longer-term risks are often tied to the general economic outlook, both local to where the business operates and more broadly. Or they involve the industry’s maturity, and that of any technology at the heart of the business – and emerging innovation that could change the playing field.
Often the most significant “value-add” provided by a business valuation is the comprehensive, clear-headed and objective assessment of risk, and its meaningful quantification. Experienced human intelligence plays an irreplaceable role in assessing individual business risk. Said another way, data is just data without human intelligence to evaluate actual risk.
Value Based on Capital Equipment and Other Assets
Yes, capital equipment can contribute to and is included in the company’s total value. The equipment’s age and condition are factors, as are its likely (or unlikely) liquidity in the event of a sale. Unless their equipment is specialized and in high demand, business owners can expect to see relatively low estimates for it as part of the total valuation.
Other assets commonly expected to contribute more value than they actually do include a business’ unique differentiator or proprietary product. For the purposes of the business valuation equation, the more closely those assets tie into actual cash flow, the more they contribute to value.