The concept of valuation is a fundamental finance principle that essentially employs an entire investment banking industry. Yet, it is a highly nuanced process where outputs between 5 different people can have 5 different results. In this sense, valuation tends to be as much an art as it is a science. Nonetheless, there are several fundamental factors that impact this valuation. If you are thinking of buying or selling a business, the valuation is a key consideration, and for good reason. Overpaying for a business can lead to dilution of earnings and reduction in shareholder value. Conversely, selling a business for a lower multiple translates to leaving money on the table. To avoid this, it would be useful to focus on the following:
1) Earnings history
Evaluating the quality and stability of earnings over the past three to five years can help in assessing the forward-looking value of a business. It is important to note that past performance is not necessarily indicative of future results, but serves as a good foundation to assess a company. Positive growth and relative consistency in gross income, earnings and free cash flow can bolster a valuation while declining or even volatile earnings can depress value.
2) Growth prospects
While highly subjective, growth potential is another critical consideration for investors looking to triangulate a suitable valuation. This growth potential can either be derived from the industry that the company is positioned in or can be assessed on a standalone basis depending on the business’s unique characteristics. In the former case, a technology business would likely fetch a higher multiple than a business within a declining industry. In the latter scenario, a business with barriers to entry such as patents or proprietary resources would again be attractive for the future growth it can offer by keeping ‘copycat’ competitors at bay.
3) Diversification
When it comes to a business, diversification can take a number of forms including client, geographic and product diversification. Ultimately, by diversifying a business, a business is lowering its exposure (risk) to one specific variable. When it comes to client concentration, relying on a small number of clients for a disproportionate amount of overall revenues is a risk as the loss of one client can materially impact top-line revenues. Similarly, by diversifying geographically, businesses protect themselves from downturns in one market, and by diversifying by product, they hedge themselves against the impact of one product becoming obsolete. Therefore, the better the diversification from a customer, supplier, market and product standpoint, the better the valuation multiple that a buyer would be willing to pay.
4) Reputation
A company’s reputation within the broader community can be another factor that elevates multiples. In this regard, having a strong brand presence and trustworthy management team and employees are vital in representing the company positively to external stakeholders. If a buyer is convinced that they would be gaining a powerful brand and/or strong employees, they would likely be willing to pay higher multiples to acquire the business.
5) Capital Allocation Track Record
Over the life of a business, management may make acquisitions and/or other large capital expenditures in fixed assets such as property, plant and equipment. Depending on how these acquisitions have impacted the business’s revenue generation capabilities and earnings strength, they can either increase or decrease valuations. Poorly executed capital allocation can lead to increased debt (and thus reduced cash as more interest is paid) while sound capital allocation can grow the enterprise value of the company over time. By practicing prudence in this regard, a company can grow its equity value and subsequently, attract higher multiples.
At Verdani Capital, legacy for employees and brands is important. Our mission to build on your already successful business, to create long-term value for all involved.
To find out more and to get an unbiased valuation on your business, contact us
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