The First Principles of Business Valuation Every Entrepreneur and Business Owner should Know
What is value? In essence, value is the sum of net cash inflows from an asset during its lifetime. It is the sum of return on capital and return on capital discounted for the risk and time value of money.
Expected Cash Flows in The Future
The cornerstone of business valuation is the expected cash flows in the future. These are discounted back to their present value. The discount rate is based on the risk associated with the cash flows or the business. The higher the risk, the higher the discount rate and the lower the value. The discount rate also accounts for the time value of money.
Valuation Is Always Prospective
Business valuation looks forward to the future. The past of the business is only used to judge the reasonability of future expectations. The past results also provide a baseline. For example, during Covid times, the valuations were based on life coming back to normal in the future. However, those challenging times had the effect of making people pessimistic about what the normal future would be like.
This is an important point. We come across businesses that are currently losing money, but they have some convincing strategic initiatives in place for growth and profitability.
Market Conditions Matter
The market dictates the appropriate rate of return. The economic and political climate, industry trends, technological disruptions, market mood, and dynamics have an effect on valuation. For example, during the third quarter of 2024, the market multiples dropped because of political uncertainty in the US. We expect the multiples to have gone up in the fourth quarter of 2024 because of general optimism in the stock markets after the US elections.
Symmetry Between Risk and Return
This is an important concept to understand. When the equity risk premium (ERP) is calculated for US equities, it is based on the excess return on equities (public) over the risk-free interest rate. In other words, the higher the expected return, the higher the risk of obtaining those returns in open and competitive markets.
A Point in Time
Valuation is always done at a specific point in time. Valuation dates are always important in valuation reports. Any event after the valuation date can substantially change the value of the business. Valuation is a function of facts known or knowable at that point in time.
Value Is Influenced by Liquidity
Liquidity simply means the number of prospective purchasers interested in the asset. the greater the number of prospective purchasers, the greater the liquidity and the higher the value.
Valuation Is Both an Art and a Science
Financial models and data analysis are very important scientific tools, and they have been growing in importance. However, experienced judgment, the ability to assess qualitative and quantitative factors, and adjust them to unique situations need mastery of the art.
Tangibles and Intangibles
It was a belief that the higher the tangible asset base of a business, the higher the value of the business. However, in current times, businesses such as software, services, and advertising have hardly any tangible asset base, but their intangibles, such as intellectual property, brand reputation, and customer relationships, can be worth billions.
Conclusion
Business valuation is an art and a science that blends financial analysis, strategic insights, and experienced judgment.
If you are curious about your business’s value or want to explore how valuation can benefit your strategic goals, please reach out to us for a 15-minute personal consultation.
Email: [email protected]
Phone: 6472977025
Visit: www.sankulinc.com
Visit: www.businessvaluegrowth.com