What's your company worth?
What's your company worth?
February 16, 2017 | by Paul Ouweneel, Wipfli LLP
It’s essential for business owners to understand the value of their company, now and in the future, to make informed financial decisions both on a personal level and in managing their business.
Regrettably, many owners do not pay attention to the value of their company until it comes time to sell or transfer their ownership interest, which is often too late and can lead to poor sale outcomes. Putting together a thoughtful plan and taking the time to improve the company are key elements in driving the value and successful sale or transfer of the company. It is vitally important for a business owner to understand what constitutes value in the marketplace—namely, how a potential buyer will value their company.
Too often, owners believe the value of their company is directly correlated with the amount of “blood, sweat and tears” they have put into it. Unless those efforts can be monetized, a prospective purchaser is probably not interested in an owner’s humble beginnings or legacy. A prospective buyer, however, does care deeply about the company’s risk profile and return potential—both of which are the foundation of how the value of the business is defined. The higher the return potential of a company, the higher its value; likewise, the lower the return potential of a company, the lower its value. Additionally, the lower the risks associated with the expected return, the higher the value of the company; the higher the risks associated with the expected return, the lower the value of the company. These risks can be internal (i.e., customer concentration, limited management team, etc.) or external (i.e., economic environment, regulatory environment, etc.).
Another important consideration is that buyers may value a business based on what they expect to happen after the close of the sale. Historical financial information is important to the extent that it may be a guide for future performance, but a discerning buyer will also carefully consider how the company and industry will change over time. For example, think of the printing industry: a printing company may have positive historical financial statements; however, in a world that continues to move away from printed materials toward digital mediums, the future performance of a printing company may be drastically different than its past.
How buyers define value is similar to the business valuation methodologies appraisers and finance professionals use to measure value—in many cases, businesses are appraised with the same methodologies used to value real estate or equipment or intellectual property. There are three approaches to valuation:
- The income approach attempts to determine the present value of a business’s future cash flows through the application of a discount or capitalization rate.
- With a market approach, transaction multiples of similar companies in similar industries are applied to the business’s ongoing earnings. The market approach is similar in theory to how your realtor values your home through the research of sale prices of similar homes.
- The cost approach simply assigns a value based on what it would take to replace the business with one of equal utility.
There is no single correct method, and multiple methods may be used in conjunction with each other. Most operating entities are valued using the income and/or market approaches, as the value of a company’s intangible assets is captured in its earnings. The cost approach, on the other hand, typically only focuses on the value of a company’s tangible assets. In the income and market approaches, the risk profile of the business directly impacts the discount/capitalization rate or multiples applied.
As is the case with any other investment, a business’s fundamental value ultimately comes down to risk and return. An owner who knows the value of their company and understands how value is measured can drive their business decisions in support of a more favorable valuation when the time comes to exit the business. Do you know the value of your company?