A financial valuation is critical to succession planning, whether it’s accomplished by selling the business, establishing partner ownership percentages or seeking financing. The exit strategy will hinge on valuation that, among other things, will consider earnings, assets and how the business compares to its competition.
In a broad sense, a financial valuation takes markets and market timing into account. Depending on the nature of the business, experts may also dive deeply into the value of equipment, inventory and property as well as management structure, projected earnings, share price and revenue.
Financial valuation is an art, not a science. While some valuation models rely on objective measures to analyze the business, others are considerably more subjective. Therefore, the business owner should look for an expert with sound judgement and lots of experience.
For a formal business evaluation, they may want to hire an accredited business appraiser. These experts are regulated by reputable organizations like the American Institute of Certified Public Accountants of the American Society of Appraisers.
Another option is to hire a business broker who can offer and opinion of value based on personal analysis, industry expertise, comparable past sales and knowledge of local markets and lending. Brokers also have connections with investment bankers, lawyers, accountants and other professionals to assist in the sale.
Business owners in the early stage of the process may want to seek a calculation of value. Offered by qualified appraisers, this is preliminary value of limited scope for planning purposes. Later, it can be expanded to a formal valuation.
Generally, there are two main methods used to determine a company’s value. Here is more about them and how their models work:
Absolute Valuation Based on Intrinsic Value
- Discounted cash flow model: Estimates value based on expected future cash flows. Considering the time value of money, it calculates the present value of expected future cash flows using a discount rate.
- Discounted dividend model: Predicts the price of a company’s stock based on the theory that its present-day price is worth the sum of all its future dividend payments when discounted back to their present value.
- Discounted residual income model: Considers the income generated by a firm after accounting for the true cost of capital. It adjusts future earnings estimates to compensate for the cost of equity.
- Discounted asset-based model: Determines value using a discounting metric to calculate the present-market value of its assets.
Relative Valuation Based on Comparison to Competitors
- Price-to-earnings ratio: Calculates value by dividing stock price by earnings per share. This model may also use ratios based on price-to-sales, price-to-book and price-to-cash flow.
- Precedent transaction analysis: uses historical transaction data from mergers and acquisitions to determine what investors are willing to pay for a company.
- Enterprise multiple: Uses a ratio that considers a company’s debt and cash levels in addition to its stock price and relates that value to the firm’s cash profitability.
- EBITDA/EV multiple: Measures return on investment based on a theory that when firms are comparable, the same metrics can be used to determine the value of one firm based on the value of another.
A financial valuation is at the heart of succession planning. Professional appraisers and brokers blend art, science and experience to help the business owner determine the right price for their company, setting a value that will compensate them for their hard work and business savvy and maximize their return on investment.