Meaningful Business Valuation THRIVES on Complexity and Detail!

A business advisor recently mentioned that they were speaking with a business owner who wanted to plan for the future.  The advisor suggested that it would be wise to have a formal business valuation done so that informed decisions could be made in the planning process.  The owner responded that their business couldn’t be valued because it was too complex for someone else to understand.

This business likely has numerous business segments or cost centers that the owner believes no business appraiser could understand. In reality, the more detailed and complex the financial information is, the more meaningful the conclusion of value will be.  Why? Because the appraiser can really focus on the differences between the business segments and model the impact of these differences. Typically these differences can impact both expected growth and profitability of each segment.  In fact, this level of complexity is yet one more reason to avoid popular rules of thumb and multipliers that could never account for all of the complexity that makes each privately owned business so unique. 

Recall from our earlier blog that any private business is valued by first considering and adjusting the recent historical trends; but ultimately, these trends help to model the company’s FUTURE business plan. This business plan being modeled needs to reflect the same level of detail and complexity that has been tracked historically.  Ultimately, this model quantifies the cash flows that will be available to an owner of the business, after operating and re-investing in the company.  These cash flows are then discounted back to the date of valuation using a discount rate that reflects the risk of those cash flows actually occurring.  The discount rate is unique to every business (even if in the same industry) because it incorporates the qualitative factors that increase or decrease risk to that particular business.  (See our earlier blog on these qualitative factors.) Ultimately, whether a business has $500,000 of revenues or $500 million, the valuation steps and process are the same; but the outcomes certainly are not.  It's the details that matter. This is because every privately owned business is unique, unlike publicly traded companies.

Let’s look at an example.

Rather than just having one sales category and cost of goods sold for that single category, let’s assume ABC Company has 3 different types or segments of sales activity that are tracked separately:

  1. 1. manufactured products–growing more slowly with gross profit of 65%
  2. 2. assembled products–growing more rapidly with gross profit of 78%; and,
  3. 3. resale products–(meaning they purchase the product already completed and sell it to the end user)--growing but more slowly than the manufactured product segment–with gross profit of 50% .

Each of these sales categories has different expected growth rates, just as each segment has a very different “cost of sales” or “cost of goods sold”, resulting in varying gross profit margins for each segment.  It is critical, if the financial statements capture this detail (and we would certainly hope they do), that the valuation model of future cash flows also be completed at this same level of detail.  For example, if the raw material prices for manufacturing products are  increasing, this increase needs to be modeled into the manufactured products’ cost of sales (thereby reducing gross profit for this business segment); whereas this increase does not necessarily impact the other two product segments.

Similarly, it is also a misconception that a business owner needs to find a business appraiser that specializes in the company’s particular industry in order to understand the complexities of a particular business.  Capital Valuation Group has been valuing privately owned businesses since 1974 (we’ll be celebrating our half century mark next year!) and we can prove that even if two companies are in the same industry, they can be different as night and day.  Why?  Because a privately owned business owner has full latitude to decide the operating model they believe is best.  This means modeling the owner's specific business model, which ultimately can result in quite different value conclusions. 

Here are just a few examples of how an owner’s operating decisions impact business models, and ultimately, the value of the business:

  • Do they have physical 'bricks and mortar' building/factory and equipment, or do they facilitate having the work completed by subcontracting to others?
  • Do they grow organically or buy other companies to create growth?
  • Do they hire employees or work with a staffing firm to have temps doing the work? Or do they use independent contractors?
  • Do they provide vehicles for their executives?
  • Do they contract with outside sales reps or hire their own internal sales force?
  • What level of debt do they have currently and what is their tolerance for additional debt?
  • Does the owner continually re-invest in the company’s assets (replacing or maintaining) or do they limp along and have assets that need to be replaced?
  • Does the company stay current with technological advances or is it stuck in “this is how we’ve always done it?”
  • Does the company have a dynamic website?
  • Does the company engage in digital marketing/sales?
  • Does the company pass along freight costs to the customer?  If yes, is it a straight pass through or are the freight charges marked up?

Each one of these items impacts the company’s cash flows and therefore its value. And this is just a sample list of some of the differences we’ve witnessed between owners. 

What DOES matter in business valuation is finding a credentialed and business savvy appraiser who will take the time to learn about all aspects of the business, no matter how complex.  This requires gaining a solid understanding of the company's history, but far more important to valuation is where is the business going?  Not just where are sales expected to go, but also each line of expense.  When will the company be at capacity and need more people? More space? More equipment or vehicles?  A business owner wants an appraiser who leans in to ask relevant questions, rather than someone who seems overwhelmed by the complexity, or defaults to a database that assumes all businesses in the same industry are identical, like widgets.  Nothing could be further from the truth.

The bottom line is that any educated buyer of a company will be interested in quantifying the cash flows that will be available to them to provide a return on their investment.  This can only be achieved by developing a dynamic valuation model and a discount rate that is specific to each individual company.  No two businesses are alike, and that is something to celebrate! It’s why we have enjoyed working alongside privately held businesses and their owners and advisers.  We welcome owners who have businesses that they think are too complex for anyone else to understand.

If you would like to discuss a specific business situation please reach out to us through our Contact page or call us at 608-257-2757 and one of us would be happy to talk through your situation.

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