Valuations may be necessary, but they can also be frustrating. But there are things you can do to improve your standing. By TOM McKASKILL.
By Tom McKaskill
How frustrating it must be for a smart entrepreneur who runs an efficient and profitable company to be told that their valuation is no different to a competing business that is run in a sloppy manner. Yet this seems to be what happens in business valuations.
There is an industry norm and it is very hard to argue around it. It is as though some distant tribunal has deemed that all businesses in a specific sector look the same and therefore should be valued the same way.
Most business owners accept the imposition of a valuation method based on a multiple of earnings, often expressed as a number of times’ EBIT (earnings before interest and tax). When you ask them what this means, they cite industry practice, prior deals and advice from their accountant and business broker.
If you ask them how they can influence the multiple, they will normally state that they need to grow faster. How much? They are not sure – just more!! Not very helpful advice to the entrepreneur who wants to build more value in the business.
However, if you apply some investment theory to the problem of improving valuation, it becomes dramatically simple to see how you could dramatically increase your value on sale.
Any investment is simply a discounted stream of future cash flows. If you use the net present value (NPV) formula in your spreadsheet, you can see how projected earnings affect the investment value. Try setting out a constant annual income and see what impact different discount rates have on the NPV.
The discount rate reflects the inherent risk in the investment. Thus, the higher the risk of future earnings being achieved, the higher the discount rate that is applied to future income streams.
Using this approach, you will discover that an EBIT multiple of two equates to a discount rate of 50%, a multiple of four is close to 25%, and a multiple of six is about a 15% discount rate. You will also see that future values count more towards the NPV with lower discount rates.
Thus a 50% discount rate heavily penalises incomes beyond six years in the future, whereas a 15% discount rate still has a reasonably positive effect on the NPV out as far as 15 years.
Armed with this new insight, the business owner has much greater influence over how value can be affected. Clearly the discount rate, a means of accounting for risk in the venture, can be reduced by taking risks out of the business. Thus good internal systems, good governance, increased competitive advantage, customer loyalty, recurring revenue and account penetration as well as decreased turnover of employees, suppliers and customers, will reduce the discount rate. Bring the discount rate down from 50% to 15%, and you will improve the valuation by a factor of three.
At the same time, you also need to improve the visibility and reliability of future earnings since more distant earnings now contribute positively towards the valuation. Longer term customer contracts, more stable revenue patterns, increased recurring revenue and customer loyalty will all help improve the reliability of longer term forecasts.
And don’t forget growth. A 10% cumulative growth will double your valuation, while 20% cumulative growth will increase valuations by five.
Try doing some of these calculations – you will be amazed at what you learn about how to improve your business value.