Do you want to sell your company or business or you just want to know how much its worth? There are as many rules of business valuation as there are businesses and valuators. The major components are the revenue and expenditure trends as well as the remaining effective life of the assets. There is a very delicate formula that takes these factors into consideration. The other important component of business valuation is discretionary cash flow. These are expenses that impact the bottom line but do not take cash. Items in this category include depreciation, owners’ expenses reimbursed by the company and other similar expenditures. Most of the time, acquisition valuations can even be done without a spreadsheet – many professionals will work out the valuation on a whiteboard or even a napkin.
That sounds simple, but valuation is quite challenging. One reason is because it’s based on the ‘type’ of company and the ‘quality’ of earnings. Growth rate, predictability and market conditions are also significant, but difficult to quantify, every input to the valuation process.
Value depends significantly on market conditions. Changes in value can occur because certain types of companies are in greater demand, or because some sectors are perceived to be more attractive by acquiring companies.
The valuation process also relies on the time value of money. As such depending on how many years revenue and/or profits you factor into the purchase price, the longer the repayment period the less the money is actually worth. This coupled with the uncertainty that time brings required an educated valuator to identify and factor the risks of uncertainty and market changes. That said, the basic mechanics of valuation are straightforward. In financial terms, the value of any business is the present value of the future income stream the company will generate. The present value calculation factors in the ‘discount’ that someone would pay today for a stream of income in the future.
Customer concentration is a good example of something that affects predictability. Most valuations implicitly assume a diverse customer base. But when one customer starts to account for more than 10% of revenue, the valuation will be negatively affected because the risk that the large customer might leave becomes significant to the future earnings of the company. In situations where a single customer accounts for over half of the revenue, the fair company valuation might be reduced by as much as 80 to 90%. In these situations, agreement on prices requires the buyer and seller to reach agreement on the probability that the large customer will continue for a considerable length of time. This can be a challenge even if binding long term contracts are in place.
Valuation gets even more interesting when the company and its business model has yet to be proven in the market long enough to establish profitability margins. A large percentage of the companies that are sold in the technology area have yet to reach profitability at all, or are growing too quickly to generate any significant profit.
Agreeing on a value requires the buyer and seller to have a common view about what the profit margins are likely to be in the future and how fast they will grow. It’s easy to see how the difficulty in predicting these future financials can lead to wide variations in what different people think is the fair value.
In practice, the challenges of developing even limited agreement around a company’s future growth rate, profit margins and predictability often make the whole financial model exercise too challenging to be useful. As a result, most of the time, both buyers and sellers resort to much simpler math based on experience with similar companies
These are used every day by professional analysts who work for stock brokerage firms. The analysts’ job is to examine individual companies and then put their current valuation in perspective by comparing them to similar companies. Through analyses like these, it’s possible to generate broadly applicable rules of thumb, or multiples, to value similar companies. The most common multiples for tech companies are price to earnings ratios (P/E) and price to sales ratios (PSR).
Types of Companies
Mature companies, with low growth rates, can be fairly valued at P/E multiples of four to five, or a PSR of one (depending on their growth rate and profitability).
For younger companies, earnings are often non-existent or extremely volatile. In these situations, most valuations are based, at least in part, on multiples of revenue. For example, these days software-as-a-service companies are regularly valued in the three to four times revenue range (PSR = 3 to 4). This relatively high revenue multiple is thought to be reasonable because these companies have a high percentage of recurring revenue and good margins. It is also believed that market growth will enable these companies to grow faster than other tech companies.
On the other end of the spectrum are service companies that are essentially ‘body shops.’ These companies can only grow as fast as new employees can become productive. Typical examples are web design firms, management consultants and human resource companies. These types of companies are often valued at PSRs of 0.5 or P/E multiples as low as two or three. This is also partly because the revenue predictability of these types of companies is low and because they usually have small percentages of recurring revenue.
Every industry, and every type of company, also has its unique multiples based on key performance indicators (KPIs) applicable to that industry.
The Bottom Line:
We use software modelling to take out a big chunk of the analysis work from our detailed review. The best indicator of the true value of the business is properly reflected in correctly compiled financial statements. Send us three years’ financial statements and we will prepare a valuation summary of your business within 3 working days.