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Valuation Math

September 21, 2011 Finance

The September 7, 2011 edition of Inc. includes an article with the tantalizing title “The Math Behind Your Company Valuation.”  The first sentence draws the reader in even more by asking “Have you ever wondered what a business like yours would sell for?”  The article specifically relates to sales to “financial buyers”, who look at a purchase strictly on a return on investment basis, without any strategic synergies.

Readers with high expectations for a simple formula to apply to their business have those expectations quickly dashed when they see that the value of the hypothetical company in the article can range from $196,000 to $1.2 million, depending on the assumptions used.

The author does, however add significant value in the last paragraph with this comment:  “…as a business owner, you have three levers to manipulate in order to increase the value of your business for a financial buyer:  how much profit you expect to make in the future, the rate of growth of your profit each year, and the degree of risk associated with your future profit stream.”

The first two “levers” are pretty obvious, and most businesses are actively trying to maximize their profits and the rate of growth of those profits.  The third lever:  the degree of risk associated with your future profit stream, warrants more discussion.

Obviously, some businesses are inherently more risky than others:  a biotech startup has more inherent risk (and potential return) than an established service business with predictable cash flows.  Within a given industry, however, the degree of risk associated with a future profit stream comes down to two issues:  credibility and concentration.

Credibility relates to the assumptions that go into the projection of future cash flows and profits. 

We have all heard of “Hockey Stick” projections, where several years of flat sales are followed by huge increases in sales so that the sales graph resembles a hockey stick.  Sales increases have to be supported by reasonable, credible assumptions.  If you have a sales staff of four and plan to add one sales person, how can sales be expected to grow by 75% per year?   If your historical margin is 50%, what supports and increase to 60%?  This is not to say that such increases are impossible, just that they need to be well thought out and documented.

 Concentration has implications for risk in several areas of the business:

  • Customers:  Does one customer account for a disproportionally large portion of sales?  If so, the potential loss of that customer increases the risk of the future cash flows.
  • Suppliers:  Does a single supplier provide a disproportionately large percentage of goods for resale?  Is a single supplier the only source for a key component of your product?  Both add to risk.
  • Product:  Are sales concentrated in a fad product or one that can easily be copied by competition?  If 60% of sales are Big Mouth Billy Bass, how long is that sustainable?
  • Expertise:  This is perhaps the least obvious, but no less important.  Is there a concentration of expertise about the business in the hands (or the brain!) of one individual, normally the founder/owner?  If so, a financial buyer needs to determine if and how he can replace that expertise after he acquires the company.  If he is concerned that he may need to spend significantly more money to cover the functions previously handled by the owner, that increases the risk associated with future projected cash flows.

 

Doug Jones, Fahrenheit Finance’s Director of Fractional CFO and Controller Services, would be happy to discuss the key finance or strategic issue that you and your business face.  You can contact him at djones@fahrenheitfinance.com

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