How much is your business is worth? Business owners often assume it’s simply a question of finding recent sales of similar businesses, or looking at industry averages, and using the implied market value multiple, such as a Price/Net Income, Price/EBITDA or Price/Sales ratio, to calculate a value for their business. That is a dangerous view to take, one that leads to bad decisions when buying or selling a business, or a loss of hard earned value when taking on a new partner or investor.
Importantly, while understanding value is aided by the use of market comparisons and multiples, the derivation of business value is based on corporate finance theory, all put into a series of mathematical constructs used in corporate finance analysis, and it’s not so simple. Those mathematical constructs were used to develop the dangerously oversimplified valuation ratios such as P/E and P/Sales, and proper use of these ratios requires a thorough understanding of the underlying corporate finance theory and math.
More importantly, simplified valuation ratios inherently imply an assumption that your business is exactly like the business or businesses you are comparing yourself to, that you are “qualitatively” exactly the same as all the others. Obviously this is not true, as each business has unique strengths and weaknesses, and unique market risks and opportunities. So, to answer the question “what is my business worth?” you must not just understand corporate finance, you must also have a thorough understanding of these qualitative elements of business value.
So, what are the “qualitative elements of business value?” To demonstrate, let me offer a list of some questions that need to be answered when assessing value, organized by the 4 core parts of any business enterprise: its customers, its products and services, its organization and its assets.
Strength of Customer Base:
• How many customers are in your market, and what share do you have?
• How reliant are you on one or a few customers?
• Are all of your customers exposed to the same market risks?
• How important are you to your customers’ success?
• Do you have unique knowledge of your customers’ needs?
• What is the length, depth and breadth of the typical customer relationship?
• What is the likelihood that typical customer characteristics and relationships will change?
Strength of Products and Services:
• How many similar products or services are available in the marketplace?
• Do you compete on the basis of quality or price?
• Can your product or service be easily copied?
• How important is brand or image to buying decisions?
• Does the need for your product have seasonal or cyclical characteristics?
• Is the market need for your product or service changing?
Strength of Organization:
• What is the relative level of knowledge and skill in areas critical to business success?
• How is capacity affected by the organization?
• How difficult or easy is it to expand or contract the organization?
• What is the likelihood of a critical individual or part of the organization being lost?
• How does management philosophy, process and controls impact likelihood of success?
• Is there a need for a type of manpower that is in short supply?
• To what extent does the organization have access to external knowledge and resources?
Strength of Assets:
• How do owned or controlled assets affect competitive position?
• How sensitive is capacity to ownership or control of assets?
• Is it difficult or easy to acquire or gain control of required assets?
• Is it difficult or easy to divest assets?
• To what extent do existing liabilities limit the business’s access to the value of assets?
Keep in mind that the simplicity of earnings or sales multiples makes it very difficult to capture the qualitative elements of business value in a multiples based valuation. On the other hand, a forecast of future financial performance is well suited to the task, with the forecast model designed to reflect all of your business’s unique “qualitative” characteristics.
Also, this list of qualitative questions is not intended to be exhaustive, and the appropriateness or importance of any given question is certainly impacted by the nature of the business, or its stage of development.
For example, organizational strength is likely to be more important to the value of an early stage, high growth business. In considering the value of a more established, moderate growth business, product strength can be key. And for a mature business, its value can be most sensitive to customer and asset strength. Finally, for a business in decline or distress, organization strength takes on heightened importance again, as it will define the business’s ability to change, address its problems and return to health. If the organization is not up to the turnaround task, business value is defined by asset value.
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