The Dark Art of Business Valuation
I call it the dark art of business valuation because there are a lot of charlatans in that world. Business valuation is very interesting and yet massively misunderstood. There are businesses that make money valuing businesses, which I find incredible because the real definition of what a business is worth is what somebody pays for it. In fact, that’s all the tax man cares about—how much somebody paid for the shares in the company. That’s the true definition of value.
Years ago, when I first started out buying and selling businesses, I asked a business broker how he valued a company. He said, “You take the number of directors and multiply it by a million,” which was his facetious way of saying everybody wants to take a million off the table, so that’s the valuation.
I have heard that Harvard Business School teaches 126 different valuation models. All of those are wrong. There are 126 wrong methodologies for valuing a business because basically, a business is worth what somebody pays for it. Simple.
What Is a Business Valuation?
What is a business valuation, why is it a big industry, and why is Harvard Business School teaching 126 methodologies if they’re all wrong? When it comes to valuing a company, you basically make up the number. You pull a number out of thin air and then use one of the 126 Harvard Business School models to justify the number that you have just made up.
Remember doing your math exam at school, where you get one point for the answer and one point for showing your work? If somebody asks, “How much do you want for your business?” and you say, “A million dollars, because I’ve seen this house for $700,000 and then I’d like to buy a Porsche.” That doesn’t really work. They don’t care what you personally want. But if you say, “I want $1 million because that represents six times price-earnings multiple and I have seen other companies in the same sector selling for about six times price-earnings multiple,” they’ll say, “Oh, right, okay, that makes sense.”
All you’ve really done is used the valuation metric of a price-earnings multiple to support the number that you just made up. Now price-earnings multiples have loads of different variables. Also, they don’t fit that many scenarios. You have to come up with more creative methods of valuing to justify all the various different types of transactions that you might do, for example, when there aren’t any earnings.
4 Most Common Valuation Methods
Here are the four most common valuation methods you’ll come across:
- Return on Net Assets: Basically, it’s talking about the yield that someone will get on their capital. This is often used when you’re pitching a property transaction, like a rental property. You might talk about the yield that that person’s going to get on their capital (i.e., the “cap rate”) as a way of justifying the price that you’re charging. So, instead of the made-up number, you could say, “Because you’re going to get a 6% return on capital employed,”—which is a healthy risk-weighted return on capital compared to a
- Discounted Cash Flow: This is used when justifying assets on balance sheets for companies to an auditor, or any business where you have a contracted revenue stream. A good example is a loan or leasing company, where there are many leases signed up or different customers with associated income streams. Effectively, you sum the total amount that’s going to be received over the total term of all the contracts. This gives you one big number, which you then reduce a little as a risk discount. Let’s say you have $5 million of lease payments that are due to come in over the next five years. You might ask for $4 million as the discounted cash-flow way of calculating the This is a massive oversimplification, but that’s the basic idea.
- Price-earnings (P/E) ratio: This is probably the most common one because it’s one of the key metrics that public companies use (and it’s one of the key fields you’ll see next to the stocks and shares listings). It’s liable to manipulation because you have things like a trailing P/E, which is obviously a multiple of what the company did the previous You can also have a forward P/E, which is a multiple of what it will do next year and is highly subjective. You can have a P/E based on an adjusted net profit figure. Brokers are famous for adjusting their net profit, which means it’s not its real profit; it’s a profit it might have done if they’d done things completely differently, which is obviously dumb, but, nonetheless, smart people seem to fall for it.
- Barrier to Entry: This final one is quite useful when your business doesn’t make any money. I’ve sold a few of these. A barrier to entry valuation is what it would cost somebody else to get to a similar position to where you are now. So, for example, you might have a health club and spa in a nice downtown location with one thousand members. What would it cost somebody else to find a decent location, fit it out as a health club and spa, and get up to their first one thousand members? It might not make any money at all, but what would it cost somebody else to get there? It might be interesting to a competitor to cut out all the time and money that would otherwise have to be invested.
I remember a deal with a furniture manufacturer on that basis. The furniture manufacturer had patterns, customers, and expertise in a factory that was able to produce those items. What would it cost competitors to get to that point? I used that as the justification for the number that I had made up.
When you’re thinking about valuation, it’s easy to get lost in everything you read. People who have been reading Mashable or TechCrunch assume that their start-up is worth 100 times their revenue, or some other crazy amount. That kind of strategic acquisition or Silicon Valley acquisition is not the norm. These are perversions in the economy, and you really shouldn’t plan your business around getting some insane valuation.
In my next blog, we’ll talk about a key component to doing deals: Special Purpose Vehicles. No it’s not a cool automobile, but it does make doing deals easier. More on that next time.
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