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Getting to a business valuation requires careful forecast

AN ANNUAL BUDGET IS FINE, BUT INVESTORS WILL WANT TO KNOW WHAT THE FUTURE HOLDS

 “All intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock."

– Charlie Munger



John Wilson, CEO of Ace Business Stuff, spent the last few weeks preparing for his meeting with Lary Columnist. He called a few days ago to follow up on his recent conversation with his attorney, Frank Lee Documents, when they spoke about investors, dilution and valuation.

“Hi, Lary. I appreciate your coming by to meet in person to talk further about some of the issues we discussed a few weeks ago. Can we talk about valuation first, since that seems to be the foundation for conversations with prospective investors?”

“Sure, John,” said Lary. “I think you’ll find from our conversation that valuation is one of the cornerstones for such discussions; but your company’s performance, as well as its promise, is really the foundation for such discussions and is equally important to the discussion of valuation itself.”

“I’m not sure I follow you, Lary. I understand the performance part – what we’ve done historically will have a lot to do with what the company’s worth – but what does the future have to do with our valuation now?”

“John, let me give you a brief overview of the valuation process, which I hope will make it clearer. As you’ve already figured out, valuation is as much an art as a science, and there are many subjective factors to consider. Certain judgments about future conditions in your industry, for example, and in the economy can be thought of as subjective information since nothing in the future is really objective. There are also other factors relevant to the final valuation outcome like the purpose of the valuation, the calculation of invested capital and the various discounts that often apply. If we don’t get to those today, we’ll talk about them next time.

“In the meantime, let’s cover the two most prominent approaches to value a company’s shares. For each approach, a certified appraiser will select the appropriate method to apply based on the company’s characteristics. Once their work is complete, all of the findings will be taken into account to come up with a fair market value for the company.

“The ‘market approach’ looks for relevant information among public companies or about the sale of comparable private companies. As you know, there is a gold mine of information available about public companies, but it is more limited for private companies. Appraisers are looking for public companies in your industry with characteristics similar to your company. They will then consider those stock prices and the relevant metrics that may apply to your business.”

“But there aren’t any public companies like ours," said John, “at least none we know about. So how is that going to help?”

“That’s only one method, John. An appraiser will also want to look at the sale of comparable private companies from the growing variety of databases available for this data.”

“Can you give me an example, Lary, to illustrate what you mean?”

“Sure. Let’s say that we find a few companies, with around $20 million annual sales volume, that were sold in the last 12 months or so. Let’s further assume that they were sold for something like 1.2 times revenues or 4.5 times EBITDA. We would then try to determine the comparability of your company to those examples. Do you use a similar distribution channel to sell comparable products? Are the general levels of profitability similar? Are the growth rates in the same ballpark, that kind of thing? Then you could apply similar metrics to get one estimate of value for your company.

“The second approach is the ‘income approach,’ which is usually the most important for private companies. That approach typically looks at the cash flows, from future revenues and expenses based on a forecast that you provide, to arrive at a future value. Then, that stream of cash flows is discounted at a rate that reflects the risk associated with achieving those cash flows. That’s why your company’s future promise is so important.”

“I see what you mean, now. I don’t think we’ve ever put together a real forecast. I mean we do some budgeting each year, but usually only to get some idea of our expenses. Is a complete forecast that essential?”

“In my experience, it is, John. For one thing, an investor is likely to ask ‘What are your plans for the future?’ since they are rightfully looking at how their investment is going to be repaid with an appropriate rate of return. Responding ‘I don’t know’ might not be very appealing.”

 “I see your point, Lary. Even though we can tell our story, without anything written that illustrates the revenue growth and profitability, it will seem like we haven’t done a very thorough job in evaluating our own future. I’ll sit down with Tom Sampson and hammer something out this afternoon.”

“John, this is not something you’ll be able to cobble together in a few hours. You need to think carefully about your underlying assumptions for revenue and expenses and make sure they’re well documented. You’ll also want to get some input from your leadership team about your plans, as well as the related cost structures and investments that might be required to support those plans. If you haven’t done it before, you’ll need to set aside some quality time to do it.”

“Getting investors isn’t as simple as I thought, but I think I understand why it’s important to get it right. I don’t want to give up more equity than absolutely necessary, and the better job we do up front, the better result we’ll get. By the way, does all of this have anything to do with what my attorney mentioned about financial buyers versus strategic buyers?”

“It all ties together, John,” said Lary. “The next time we get together to review your forecast, I’ll show you a useful diagram to explain those principles. In the meantime, you’ve got a lot of work to do.”

•••

Lary Kirchenbauer is the president of Exkalibur Advisors Inc., providing practical business strategies for family and other privately owned businesses in the middle market. He works closely with senior executives and their businesses to accelerate their growth and improve personal and professional performance. His Web site is finally operational, so stop by to offer your comments on the column or other business issues at www.exkalibur.com.