Only three things drive the value of a business: Future cash flow (or profits), the risk of achieving the future cash flow and the growth of the future cash flow.
Back To The Future
Although historical information is used to establish a value, it is the expectation of future cash flow (or profits) discounted to the present that is the primary value driver of a business.
Cash (From Profits) Is King
Profits and cash are not the same. Cash comes from the business’ profits, its borrowings and the owner’s equity contributions. Cash flow statements are very useful.
Goodwill Is Not Forever
The elements of a business that cause customers to return to that business are collectively called goodwill, which can be enterprise (business) or personal. A business goodwill element could be its convenient location. However, unless the owner owns the real estate, his business is worth less because his lease is not forever. Personal goodwill, by definition, is inextricably connected to its owner. So when the owner retires, his goodwill retires with him. Warren Buffet buys companies with “durable” goodwill.
The owner’s compensation is the major factor in the sale of very small businesses (transactions under $100,000). Transactions over $500,000 begin to indicate a size premium (higher valuation multiples). These larger businesses tend to have more management and are less dependent on the efforts of the owner (less personal goodwill).
Controllable Cash Flow Is Not Discretionary
The owner has the power (or control) over cash. For instance, she has the power to postpone paying for invoices that are due and replacing aging equipment. However, she does not have the option (or discretion) to NOT pay for these for obvious reasons. Controllable cash flow, which has more to do with the timing of the cash outflow, ignores the working capital and capital expenditure requirements (economic realities), which may affect the profitability and going concern of the business.
Liquidity Is A Myth
The real value of a business to the marital estate is to the in-spouse, a market of one who may not have the financial ability to purchase the interest of the out-spouse. Nevertheless, here is some perspective: (1) not all small businesses sell and (2) if they sell, they are on the market for over six months on average (and sometimes for more than three years).
The Trend Is Your Friend
If the profits of a business are trending lower, then its value is probably diminishing (and vice versa). If the industry is declining, then the value of businesses in that industry are probably declining too (and vice versa).
Too Many Thumbs
Rules of thumb are useful when there is limited financial information available and the valuator needs to develop broad value parameters, which often means more than one value (or thumb). The “thumbs” change because of inflation and the popularity of a business.
Wanted: Dead or Alive
Some businesses are worth more dead than alive. For example, the liquidation value of a business with fixed assets, without debt and with the expectation of continued losses is probably higher than its going concern value.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.