Disclaimer: This article simplifies the method used by business valuators to determine what value a business might command in the market. It is not in any way a substitute for a professional valuation, and the author is not a professional business valuator. It is for reader interest only, to inform you about some of the factors and methods used in business valuation.
![]() The traditional rule of thumb is that a business is worth the Present Value of its expected future net cash flows (i.e. cash taken in less cash paid out). The discount rate used to compute the Present Value should reflect the risk (uncertainty) of realization of those cash flows — the higher the uncertainty, the higher the discount rate and hence the lower the business value. This assumes that the business is a ‘going concern’, i.e. that it makes sense to continue to operate it to realize those future cash flows. If this computed value is less than the liquidation value of the business (the realizable value of the assets less liabilities if everything was sold as-is today) then the business is worth its liquidation value instead (and consideration should be given to winding it up). Here’s a step-by-step method for computing an approximate ‘going concern’ value:
Professional business appraisers have developed sophisticated methods of determining appropriate capitalization rates based on analysis of recent comparable business sales. Also, some assets have additional value (or in some cases diminished value) depending on the tax treatment they will receive in the hands of the buyer, or when ownership is transferred. In addition, the tax and accounting treatment is different depending on whether it is the business entity’s shares, or the assets and liabilities, that are sold, and this also affects the business’ value. If you’re interested in learning more about business valuation, here’s a Powerpoint presentation that shows many of the techniques that business appraisers use, and much more detailed valuation formulae. But remember, these calculations are the theoretical value only. The computations are only as good as the quality and validity of the underlying assumptions and forecasts. And the market often behaves in unexpected ways, ascribing value because, for example, the purchase offers synergies or sentimental appeal to the buyer. In addition, buyers sometimes ascribe too high or too low a capitalization rate because of inaccurate perceptions of the risk or growth potential of the business. And sometimes the real value of the business is in its key management members and employees, who, if they’re not motivated to stay with the new owners, can severely reduce or even eliminate the business’ value to a purchaser. That’s why few owner-managed businesses command the market price their owners expect. A surprising proportion of all mergers and acquisitions fail to add as much value to the buyer as expected. I’d like to see a Monopoly-type game that used these theoretical valuation calculations to set and constantly adjust prices for each property on the board, and allowed players to buy and sell any property, with some serendipitous variation in the calculations built in to make the game interesting and life-like. It would be a great educational tool that, if it also included a simulation of business operations, could help provide our young people with some valuable entrepreneurial skills and insights. Anyone for Sim-Biz? |
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