Top 5 Fundamental Issues to Valuing a BusinessJanuary 03, 2011
While nothing can compare to a thorough and detailed valuation, I have complied what I believe to be the top 5 issues to consider when valuing a closely held business:
I recently was asked to speak about business valuations at the Boston Business Alliance’s monthly educational seminar. After wowing everyone with my intellectual prowess, I was asked if there is a “cheat sheet” or a one page summary to help value a business.
This is probably the single most common question I’m asked as a valuation professional; the proverbial “back of the envelope” valuation. While nothing can compare to a thorough and detailed valuation, I have complied what I believe to be the top 5 issues to consider when valuing a closely held business:
1.Opportunity Cost of Capital: Every investment out there is competing for the same dollars. An investment in one opportunity is done at the cost of not making an investment in another opportunity. You need to understand how your company measures up to these other investment opportunities before you can even begin to put a value on it. This is akin to determining the riskiness of your company as an investment.
2.Cash Flows: Remember the old adage “cash is king”? Without expected positive cash flows, an investment is technically worthless. Note that net income is not the same as positive cash flows. Even with very high net income, you can still have negative cash flows if, for example, you have to make significant reinvestments to keep the company going or you have large debt payments to make.
3.SWOT Analysis: SWOT stands for Strengths, Weaknesses, Opportunities and Threats. You need to have a candid internal and external review of these four categories to be able to value a company. Remember that sometimes strengths can also be weaknesses and opportunities can also be threats. For example, having a large customer (strength) can also mean that you have a high dependency on that customer (weakness). Also, being the first to launch a new product (opportunity) can also mean that others can learn from your mistakes (threat).
4.Future Returns: We’re all guilty of looking at historical investment performance in picking where to invest. Although this methodology is intuitive, it’s also fundamentally flawed. The value of any investment is determined by its ability to generate future returns. Only when it can be reasonably assumed that historical performance is a reliable indicator of future performance should we use historical data.
5.Buyer’s Perspective: There is no single value for a business. Just like beauty is in the eye of the beholder, so too is the value of a business. What might be very important to one buyer may not be for another.
These are my picks for the top 5 most important business valuation topics but it goes without saying that there are many more. Did I miss any that you think should be on this list? Please feel free to share!