“What is my business worth?”
That is the question every private business owner will ask at some point in time. While publicly-held businesses can instantly derive values from stock markets, the owners of privately-held businesses have no such markets available. Notwithstanding, the underlying concepts used to value public businesses are equally utilized by potential buyers to value private businesses. As a result, private business owners contemplating a sale of their business need to understand the basics of private business valuation to ensure good results.
Let’s dive into an overview of private business valuation concepts, including a general discussion of value and of the most commonly used business valuation formula components.
Despite the subjective nature of value, generally-accepted valuation formulas are commonly used by market participants. While the values of the components of a valuation formula are subjective, the formula components themselves are objective; and, in the case of business valuation, are based upon generally-accepted valuation theory.
Since businesses are economic assets, their values derive from expected future cash flow returns to a business’s debt and equity investors. More specifically, business value is a function of two variables: earnings, and a required rate of return. Both variables are affected by growth expectations and risk and are discussed later in more detail.
It’s also imperative for business owners to understand that value is not the same as price. Warren Buffett, considered by many as the greatest investor of all time, explains it best: “Price is what you pay. Value is what you get.” Value is a function of estimated formula components – cash flow and rate of return. Price is a function of supply and demand. Anyone planning to sell a business needs to know this difference. By establishing an estimate of value, you have a reference point for evaluating price offers.
From a business owner’s perspective, value is equal to what the business is worth to the owner at a given point in time, based on its estimated cash flow, growth, and risk.
What are we Valuing?
While it seems obvious that in a business valuation, we are indeed valuing a business, knowing precisely what the term business means is critical. In a transaction involving the purchase and sale of a business, both parties must agree on exactly what will be transferred from the seller to the buyer in exchange for cash or other consideration.
In the context of a business sale, the “business” to be valued includes the collection of assets and liabilities employed by the business to produce a profit. These can be arranged into the “Business Enterprise Components” as shown below, which are utilized in operating activities to generate earnings in the form of cash flow from operations.