Friday 20 May 2016

Tip to Valuing a Business - Get the Story Right!

One of the biggest misconceptions out there is that the process of valuing a business is really just a hardcore quantitative exercise that consists of endless excel spreadsheets with complex financial models. Sure, business valuation does have a quantitative slant to it and, yes, there are excel spreadsheets involved. However, the more important point to grasp is that at its heart, a business valuation is all about the future of a business, not its past. And... because the value of a business is about its future then that, therefore, requires a really strong grasp of the 'story' behind the business which is then translated in a quantitative analysis. Too many people, including some professionals, tend to put the cart before the horse and simply jump right into their financial modelling without trying to understand first the story behind the business that should be driving the numbers, not the other way around.

You need to know the story behind the numbers

Buyers of a business care about the future of the business. They care about the future cashflow that the business is expected to generate and they care about the riskiness associated with the future cashflow. As a business valuator, I look to the past results of the business only to the extent that they may help me to understand what the future of the business might look like.

So.... if the future is so important for business valuation, then it is critical to have a reasonably strong grasp of what the story behind a business is. Is the future of the business expected to get better? Worse? Stay the same?

If you were to value a business like Uber or Twitter, or Google, it is fairly intuitive to realize that understanding the story behind these types of businesses is critical in understanding their respective values. In other words, you couldn't simply get the historic financial statements of these types of businesses and then start building a discounted-cashflow valuation model. You would first need to try and understand what the future may look like for these businesses. You would need to try to surmise their plans for the future, the marketplace, other disrupters, technology, regulation, and so on, and so on. In other words, if you wanted to value a company like Uber you would really need to understand the story behind the company and then translate that story into a valuation model. The key point is that this same principle holds true for any business.

When valuing a business you need to understand the story behind the business – even really small businesses

If you were trying to value a straightforward small business like a local pub in town that generated consistent revenues and profits over the years you would still need to consider the value drivers behind the business. Sure, it may be tempting to take the last 3 years average of profit and apply a multiple to it, but that wouldn't be correct. You still need to understand what is going on in the business and how that impacts the value of the business. For instance, is the business being run efficiently? If the management of the pub was sub-par then perhaps a new owner can come in and tighten up the operations and improve margins and that would theoretically improve future cashflow. What would that be worth to a prospective buyer? Perhaps there is a new competitor expected to open up down the road next summer – how would this impact the business valuation? Perhaps the pub was involved in an underage drinking scandal that tainted its reputation – how would that affect value? Will changing demographics have an impact on the pub's value as the population base gets older?

The key is that valuing a business is not simply a quantitative exercise. It is easy to get caught up in the complexity of things like costs of capital and betas and tax shields but the reality is that the key to a really strong business valuation is first getting the story behind the numbers right (or as close to right as you can get!)

Steve Skrlac, MBA, CFA, CBV
Keystone Business Valuations

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