How to value a business

Every business is different | bizval Business Valuations UK & USA

Playing every valuation octave

Even if Ode to Joy or the melody of Clocks isn’t in your piano repertoire, you’ve probably at some point in your life sat at a keyboard and given Jingle Bells a go. Even with rudimentary exposure to a piano (or even a keyboard), it’s clear that there’s a big and exciting world beyond Middle C. This article explores how we apply these principles when we think about how to value a business.

Still, Middle C is important. In fact, it’s the note that beginners use to find their way around a piano. It’s the rule of thumb, sometimes literally! In valuations, Middle C would be the “I heard that everyone pays 4x earnings” approach to making an offer for a company.

As a Hans Zimmer YouTube video will quickly reveal to you, moving beyond Middle C leads to a far deeper and more impressive outcome on the piano. The situation is no different when it comes to valuations, which is why we strongly believe that earnings multiples are the outcome of a valuation process, rather than the driving force.

Allow us to explain.

How to value a business – every business is different

Here are just some of the ways in which business models tend to differ and we explore these as we unpack how to value a business:

  • Recurring vs. ad-hoc revenue
  • Many vs. few customers
  • B2B vs. B2C value propositions
  • High vs. low gross margins
  • Scalable, automated expenses vs. dependency on labour
  • Ongoing advertising costs to drive each sale vs. brand awareness
  • Asset-light vs. asset-heavy

We’ve barely even scratched the surface here. Clearly, not all companies are created equal. They have different risks, which means that Finance 101 requires the companies to offer different returns to investors to justify their existence.

All this, captured by a “rule of thumb” earnings multiple?

Not on our watch.

How to value a business – which valuation model is best?

In our opinion, a discounted cash flow valuation model is the best way to understand the true drivers of value going forward. By forecasting revenue growth, elements like recurring vs. ad-hoc revenue and customer dependencies are considered in the process. Gross margin is another specific forecast, with due care given to whether margins should be consistent in coming years vs. expanding or contracting.

By building out a reasonable forecast of how the business is going to generate cash for investors, there’s a deep thought process that gets to the crux of the operation and its future. Not only does this improve the accuracy of the valuation, but it helps the owner of the business understand the core drivers of value.

The other element to this approach is of course the discount rate. The final answer is very sensitive to the rate used. The actual name is very confusing for founders, as it making it sound like the business must be sold at a discount. Perhaps a better term would be the “required rate of return” based on the risks of the business. In other words, this is the rate that an investor would demand when investing in these cash flows. By discounting those cash flows back to today at that rate, we arrive at the present value of the cash flows i.e. the business valuation.

We also have a specific approach that we take to the terminal value (the worth of the business at the end of the forecast period) that addresses one of the common criticisms of this methodology. This is based on our experience in dealing with private equity investors and how they approach valuations.

In short, the discounted cash flow approach plays every octave of the piano, never mind just Middle C.

When is an earnings multiple appropriate?

The market for private companies is illiquid and struggles from a concept known as information asymmetry, which means that sellers have vastly more information about the business than buyers. This isn’t the case in a public market (a stock exchange), where investors are all working off the same publicly available information.

This is why many buyers like to simplify things by saying that they pay up to a particular multiple for a given type of business. This builds in a lot of fat for buyers, making up for any gremlins in the business. Of course, that means that sellers are often being short-changed for their life’s work.

By preparing a proper discounted cash flow model that explains the key drivers, we get to an answer that can be expressed as a multiple. Best of all, that multiple can then be justified using the underlying forecasts and accompanying information, which puts the owner of the business in a much stronger negotiating position to demonstrate that the rule of thumb isn’t appropriate.

The eventual deal will always have an implied earnings multiple and the parties involved will no doubt make reference to that multiple when speaking to business partners. Everyone knows that there are reasonable ranges for multiples, but few understand why these ranges exist or why companies are lower or higher.

At bizval, we play every octave. We empower owners to have in-depth conversations about value, giving them the tools to have successful negotiations. Speak to us about moving beyond Middle C when dealing with potential investors.