They might rely on rules of thumb, such as EBITDA (earnings before interest, taxes, depreciation and amortization) and revenue multiples to estimate value. However, this can give an inaccurate estimate of a business' value, which can lead to bad decisions and missed opportunities.
For example, if you hear a competitor sold his business for six times EBITDA, you cannot assume your business would sell for that price. Without knowing the details of the transaction, you do not know whether the same multiple can be applied to your business. How do your gross margins and sales growth compare? How much are each of your salaries? If you do not have access to all the details, you cannot accurately assess your business' value.
Some business owners assume their balance sheets show the value of their business. However, the value of most businesses is different from the balance sheet amounts, which are based on historical amounts, not current values. Your equipment might be fully depreciated and show zero value on the balance sheet. If a buyer approached you today, would you sell for that price?
More value off the balance sheet
The value of a business is based on the cash flows. To understand — and increase — value, you must learn what drives cash flow and makes the business unique.
Accurately valuing a business involves answering questions about the company and its operations. Here are some examples:
- What makes your customers buy? Could you command a higher price by repackaging and repositioning your products with an emphasis on quality or safety?
- What is the value of the company's intellectual property? Assets such as software development costs, patents and trademarks might appear on the balance sheet at a cost that does not reflect true value. Other assets, such as customer lists, supply agreements or a highly trained workforce do not appear on the balance sheet.
- What is the true cash flow to equity? Is the owner's nonworking spouse driving a $100,000 Mercedes paid for by the company? Are family members on the payroll being paid appropriate salaries? Asking these questions can reveal a more accurate picture of the company's cash flow and value.
- Is a solid management team in place? Having a solid non-ownership management team can be a huge boost to value. A buyer is concerned with his ability to generate cash flow after he has purchased your business. If the business is too heavily dependent on you, the business will have less value to a buyer.
- How well is the company managed? Is the company using its assets to its greatest advantage? Compare a variety of factors to other companies in the same industry, such as sales per dollar of fixed assets and employee, gross margin and working capital turnover. If the business has a unique product or process, is it properly utilized?
- Are there opportunities to improve the top line? Are appropriate resources devoted to sales and marketing, or are the salespeople simply order-takers? Are there opportunities to extend existing product lines or to tap new markets? Opportunities for sales growth can obviously have a huge impact on value.
- How can operations be improved? How much can cash flow be improved by streamlining operations and cutting unnecessary costs? Are there nonessential assets that can be liquidated?
- What are the company's hidden assets? Does the business have information other companies want, such as market intelligence or customer lists? Does the company have assets that would be difficult, risky or time-consuming for someone else to duplicate?
For example, one company had developed an extensive database of market intelligence on the office products market over 15 years. A large, publicly traded company purchased this company to get the database, because the larger company knew it could spend millions of dollars to gather the same information.
- Who might be interested in buying? There are many potential buyers, each with different needs, goals and perceptions of value. Buyers for an auto parts distributor might include:
Competitors looking to expand product lines.
Suppliers or customers wanting to integrate their supply chain.
Private equity firms looking for investments.
A company wanting to gain access to a particular customer.
Buyers interested in the location.
Companies wanting a known name.
Understanding who the buyers are and what is important to them is key to understanding value.
See the full picture
There is a lot more to valuing a business than the numbers on the financial statement. To understand the value of a business, ask questions and dig for answers. It takes a lot of effort, but the payoff is a solid understanding of value — and the information necessary to make the right decisions for your future.
Patrick McNally is the partner in charge of Corporate Finance Consulting at Blackman Kallick in Chicago. He can be reached at (312) 980-2934 or via e-mail at
[email protected].
