The “How-to” Value your Business so you can Price it

In my last article, I wrote about a couple of different ways to calculate a firm’s “Cost of Equity.” As we learned, the Cost of Equity is the return investors expect to receive for their investment.

For this article, I go from costing equity to putting a value on a firm.

Why business valuation is important?

Whether publicly-listed, or privately-held, having an understanding the value of a business is important. It’s important because let’s say your business is involved in a merger or acquisition. It needs a value to determine an appropriate price.

Valuations are also beneficial for strategic planning, like onboarding new partners, establishing employee stock ownership plans (ESOPs), and providing a baseline for growth initiatives or a future liquidity event.

What valuation model will we use?

When it comes valuing privately-held companies, there’s no shortage of valuation methods; however, from my experience, I use the “discounted free cash flow method.” I use this model, and only this model because it provides an intrinsic, forward-looking valuation based on a company's expected future free cash flows, rather than being tied to current market fluctuations. As the saying goes, “Cash is KING.”

The Discounted Free Cash Flow Method

The Discounted Free Cash Flow method is a 6-step process. In the following, I discuss each step, using a fictious company as an example. The 6-steps are:  

STEP 1:  Determine your Firm’s Discount Rate 

This is the tricky part. Because we’re using a discount method, we need to use a rate that brings all future values back to their present value (PV).

What rate should you use?

Unfortunately, there is no single discount rate that satisfies everyone all the time. When determining what rate to use, one must be determined by considering factors like company size, industry risk, financial stability, and company-specific risks such as dependency on key personnel or customer concentration.

A common starting point is a risk-free rate plus a market risk premium, with additional premiums added to account for the specific risks of the private company. This is referred to as the “Build-up method.” I talked about this method in my last articles.

Because the discount rate you select reflects the risk of future cash flows, it cannot be precisely calculated; therefore, at the end-of-the-day, it requires a significant degree of judgment.

STEP 2:  Forecast Free Cash Flows

The Free Cash Flow formula is:

Where:

• Earnings before interest and taxes (EBIT) is adjusted for taxes.

• We adjust for capital expenditures, depreciation, and change in non-cash working capital.

• Note: The change in non-cash working capital simply means that when calculating the change, cash is not included.

Forecasted Free Cash Flows for Years 2026 -2029

STEP 3:  Calculate the PV of the Forecasted Free Cash Flows

Using the discount rate of 10.5%, as suggested by Baur’s finance team, the PV of each forecasted free cash flow is calculated and then summed, as shown in the table below.

STEP 4:  Determine the Terminal Value

A firm’s “terminal value” is the estimated value of the business or other assets beyond the cash flow forecast period and into perpetuity. The terminal value is calculated using the “perpetuity growth model,” as detailed below.

For our exercise, the forecasted cash flow for year 2029 is expected to be $2,562,175. The next step is to multiple this forecasted cash flow by the expected growth rate the following year and beyond. The numerator value has to then be divided by the difference between the discount rate and the expected growth rate.

For our exercise, the growth rate is expected to slow down to 5%. Based on this, the following year’s free cash flow is expected to be $2,690,284 ($2,562,175 x 1.05). This value is then divided by 5.5% (10.5% - 5.0%), which gives a terminal value of $48,914,250.

STEP 5:  PV of the Terminal Value

The terminal value calculated above needs to be brought back to the present value.

STEP 6:  Sum Present Values (PVs)

Value vs. Price

Is there a difference between value and price? Many businesspeople mix up these terms, but they are not the same. If you google business valuation, you will come with the following definitions.

The common denominator of these definitions is that they all relate to the overall worth or economic benefit a business provides to its shareholders/stakeholders, encompassing both tangible and intangible assets and future prospects.

Referring back to our Case Study, Baur used the “Discounted Free Cash Flow model” to put a value of roughly $40 million for EcoTech. Is this the value Baur will offer EcoTech’s board? And is this the price that EcoTech’s board will accept? Probably not on both accounts.

Each company has its own reasons to do the transaction. From the buyer’s standpoint, Baur thinks that the acquisition will not only be profitable but also enhance its reputation/image as a business that cares about the environment. It’s possible that Baur’s management sees potential synergies with the acquisition as well, such as improved access to capital (ability to secure lower rates on loans), tax benefits (ability to carryforward EcoTech’s operating losses before 2021), acquisition of talent and expertise (ability to pool R&D capabilities), and diversification (ability to diversify its operations).

From seller’s standpoint, EcoTech’s board might simply see a good exit strategy – to get out while the going’s good. To address the risk that the valuation is not right, the discount rate, as well as doing sensitivity analysis might be advisable - to see how changes in the variables changes the valuation.

• Adjusting the discount rate

The discount rate can be adjusted up or down based on perceived risk. For example, Baur’s team could increase the discount rate if they believe EcoTech is riskier than other investments. On the other hand, they could lower the discount rate if they believe EcoTech is less risky than the company’s present portfolio of investments.

• Sensitivity Analysis

Sensitivity analysis can be used to test the assumptions used in the valuation model. Sensitivity analysis is a “what if” technique. Sensitivity analysis is one way of dealing with uncertainty in decision-making. If some underlying assumption changes or is not achieved, sensitivity analysis answers the question, “What will happen to the result?”

In the context of business valuation, price is the actual amount of money that a buyer is willing to pay and a seller is willing to accept for the business. Ultimately, price is an objective figure that’s going to be determined through negotiations at the time of the sale.

Final Word

The "final word" on business valuation is that valuation is a “blend of art and science,” and a business is ultimately worth what a specific, willing buyer is prepared to pay in a real-world transaction. The estimated value of $40 million for EcoTech is a starting point for negotiation, not a fixed, universal number.

Next

For my next blog/article, I want to talk about “how AI is impacting the accounting industry.”