All business valuation efforts require close attention to the unique qualities, dynamics, product diversity, markets, competitors, and the place in the market that a business occupies. There are shortcut approaches to valuing a business, but shortcuts bring an opportunity to mislead everyone involved. As the above statement may sound like an obvious ploy to suggest that you must hire an expert (like our firm) to provide such an analysis, the truth is that any well-meaning business owner can perform competent analysis if they so desire. Careful consideration must be given to the specific entity, the purpose of the valuation, its stakeholders, owners, investors, customers, markets, and industries, along with the climates within which it exists. Small business, small and medium-sized enterprises (SME), lower middle market, middle market, and big businesses differ in terms of magnitude, market and product diversity, and liquidity, and complexity. This is not to say that an SME cannot be extremely complex. For example, one that holds a substantial intangible or tangible technology IP portfolio. For our short discussion here we leave out the complexity of intangibles. In short, one must understand the business closely to provide a valuation. Accounting skill without real finance knowledge, or accounting and finance skill without real market knowledge of the business owners are insufficient bases from which to approach business valuation.
One of many possible combination methods that can be used for business valuation is a multiples valuation in conjunction with a discounted cash flow (DCF) valuation using forecasted free cash flow to operations (FCFO). DCF works well where the business owner(s) have accomplished the amazing feat of creating a consistent sales and cash flow performance over time due to a well admired product or service and a loyal customer base. The forecast for the DCF is the key, but only if understood as guidance, not as an end all. A forecast must be built on a solid footing, with the understanding that past data does not guarantee future performance. It must be reasonable, and period specific growth rates must be justifiable and reasonable. In one case, we built just such a forecast from five years of historical data as a baseline, and then created sensitivity tables from that forecast to provide a justifiable range.
DCF analysis, based on both historical data, and a reasonable forecast can also show sensitivities in the structure of the company being valued. Sensitivity showed, in one example, that the valuation was highly sensitive to cost of goods sold (COGS) as a percent of sales, and also sales, general, and administrative expenses (SG&A) as a percent of sales. The analysis, in this example, also showed that the valuation was not sensitive to a change in the weighted average cost of capital (WACC) used to discount the cash flows. The sensitivities can then be displayed, like the example below, in a relevant range around the actual performance of the company being valued.
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