A Best Practice for Determining Business Valuations
Some thrived. Some closed. Some crashed early in the pandemic and now are making a comeback to pre-pandemic performance levels. One thing is certain: it has not been dull.
Since early 2020, we have seen tremendous variability in the financial markets and in business performance across industries. The pandemic has had a dramatic impact on where we work and how we work. Business models pivoted to offer touch-less service, online order placement and pick-up/take-out models. Businesses have soared and sunk. During these volatile two plus years, the same business may have experienced both; soaring and sinking. Peloton is such an example, early on in the pandemic their business soared; they were challenged to keep up with demand for bikes and treadmills; yet recently they have struggled. The business cycles have been extreme.
Today, more than two years after the start of the pandemic, inflation is high, interest rates have risen and recession indicators are many.
So, with all this volatility, how has valuation of a business been affected?
Business Valuation: The Drawbacks of Looking Back
Some look at the past as an indicator of future performance. Many professionals who prepare business valuations look at the five year average of the past to forecast future earnings. The volatility of earnings in the past two years highlights the flaws of this ‘mechanical’ approach. Past performance does not result in a valid or thoughtful determination of the value of a business.
Imagine business owners who have experienced peaks and valleys during the pandemic contemplating selling their business today? A ‘mechanical’ approach to business valuation based on an average of the past five years of earnings would be problematic for many businesses across many industries. The approach is fundamentally flawed and those flaws are exacerbated by the volatility of the past several years.
Be informed. As you speak to a business valuation expert, ask the method the professional adopts to prepare the valuation. If looking back is the view they take on valuation, I suggest you move forward.
A Best Practice: Look Forward
A best practice for business valuation is applying the discounted cash flow method. I have always espoused this method in preparing business valuations and the importance of adopting this method is highlighted in today’s economic conditions and accounting for the volatility of the past few years.
The Discounted Cash Flow Method is an income-based approach to valuation that is based upon the theory that the value of a business is equal to the present value of its projected future net benefits. This method understands that the past gives insight into the performance of the business, but the past does not dictate value. The fundamental difference in methods is the lens that is used: looking to the past vs. looking to the future.
The discounted cash flow method that I incorporate into the detailed business valuations prepared to withstand scrutiny look to the future to calculate the expected future economic benefits that will flow to the business owner, net of risks.
Starting with benefits: effectively applying this method requires that a business valuation professional understand and analyze the fundamentals of the business. This includes analyzing factors affecting demand, revenue, and profitability.
Today, many businesses are experiencing high demands for their products and/or services. Demand is up, revenue is up, but profitability is being squeezed due to rising costs of source materials, labor, and transportation costs due to rising gas prices. Early in the pandemic, we witnessed high demand for contractors, tradespeople, and appliances as home improvement projects surged. Today, costs are increasing at a rate that for most industries can’t be passed onto the consumer so while revenue may be up, profit margins are shrinking.
Then we look at the risks; many of which a business owner has little control over. Such macro risks include the effects of the war in Ukraine, inflation, high gas prices, and rising interest rates.
Risks specific or unique to the business include assessing the impact of the labor shortage on business operations, supply chain exposures, and a ‘hidden cost’ that is becoming more visible: the cost of the owner filling in as an employee; working ‘in’ the business vs. ‘on’ the business. For many businesses, this will have a negative effect on the long-term health of the business as strategic thinking is traded for near-term productivity. Such risks are noted and accounted for in the discounted cash flow method to calculating the net present value of future net benefits.
A Constant in the Chaos: The Discounted Cash Flow Method
Look forward. As a business owner, keep looking ahead and if you are considering selling, do not worry about the volatility of your business looking back over the past two years. The best method for valuation will look ahead, not back.
In the midst of chaos, certainty always appears elusive. Yet, for business valuation there is a constant. The best method to determine the value of a business is to calculate the net present value of future benefits.
If you have been referred to multiple business appraisers, ask what method they use to calculate valuation and inquire about their process and their track record. While complex in nature, the answers should be clear and understandable. When Values Matter, secure the expertise you and your business deserve. Contact us so the valuation of your business is not unnecessarily discounted.