moneyFYI
Financial Freedom Is Merely Organized Common Sense
Why Value Your Business
Valuing a business is not as hard as some people think. You can get it into a range with only a little effort. It requires some common sense though.
J. P. Morgan reputedly commented that a thing is worth what it will fetch. While that is true at a given point in time, it doesn’t represent the value of a business very well. Businesses have a long life and the long lived part has value.
For a business, the better valuation statement is “A business is worth what it will earn”
From there it is just arithmetic
What do you mean by earn? In this case, free cash flow. Income for tax purposes is only slightly attached to the earning power of a business. In the early years, there will be income but the cash needed to grow may well exceed what it earns. Building for the future is expensive. Over the long term, most business assets will be consumed so the cash flow they generate is the only enduring value.
Should earnings be adjusted to accommodate the buyer’s expectation of use? Most owner-managed businesses pay the owner a salary of what he/she needs or wants. That may not be representative of what the market value is. Adjust to market. Similarly, there may be assets the business uses only slightly. The boat, the plane, the land next door they may never use. Again adjust.
There may be an asset mix that is unrelated to income and/or cash flow. Sometimes there is an asset mix that exists outside operations. A stone quarry for instance may have the intrinsic value of the stone plus an operation that extracts it. It is easier to charge the operation a fair royalty and value the reserve separately. The required rate of return may be much lower than for operations. The same with land that is underutilized.
The rate of return needed today is in the 12% to 15% range for well-developed operating businesses with nominal growth potential. Much higher for startups or troubled businesses. Much less for businesses with easily developed growth potential.
From there, consider taxation and get the net present value of future free cash flow. Not trivial but essentially a spreadsheet question. For no growth situations, you can do it with a financial calculator.
Using your knowledge
Understanding how valuation works helps with some business decisions.
- Capital budgeting. If a machine you like earns or saves 10% and will run at maximum capacity it may be an unattractive buy if your business needs a return of 15%. It still might be valuable but only if it enhances other operations in the business. Be cautious of decisions that manage the work more than the money.
- Some product lines may be disposable. If not required in your market offering package, and they return too little you may better sell them off and redeploy the cash.
- Lease versus buy. Business people eventually come to understand that owning and using are severable decisions. If you cannot replace an asset then maybe you must own it. Consider location, special permits, and grandfathered advantages. If a lease gives up too much control, you must own. Things like equipment are often better leased. You don’t fall into the sunk cost trap and you don’t tie up expensive capital when you could acquire with a financing cost at much lower rates.
- Operating costs are infinitely variable. These are an efficiency thing. Do things right. There may be options you have notj seen yet. Curiosity is a valuable skill.
- Operating businesses need management. Be sure it is there to transfer. Businesses often sell on the strength of middle management. Building that well pays in many ways.
The Takeaway
If you manage your business to make it more valuable, you will tend to make better decisions about assets and financing. Eventually, that leads to a business that is easier to sell or to pass on to children.
Pay attention to efficiency but never neglect effectiveness. Peter Drucker has proposed that efficiency is doing things right and effectiveness is doing right things.
In the long run value follows effectiveness
________________________________________________________________________________________________________
I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages—the result: more security, more efficient income, larger and more liquid estates.
Please be in touch if I can help you. don@moneyfyi.com 705-927-4770
moneyFYI 