The 7 basic principles of business valuation: Principle 2

Principle º2: Value principally varies directly with the ability of a business to generate prospective discretionary cash flow, except in unusual circumstances where net asset liquidation results in a higher value.

The value of a business depends on its future profitability (cash flow) and not on its past profitability. For example, a business that has been very profitable in the past who has now a major competitor which forces it to revise its prices downwards. This will inevitably have a significant negative impact on its profitability. Should the business be appraised based on past profitability, or based on the estimated profitability with this new competitor? The answer is, of course, that we have to consider the estimated profitability with this new competitor.

For an established business with nominal growth, past profitability is used as a starting point for estimating future profitability. Adjustments will be made to determine the true profitability (for example: adjusting the owner’s remuneration to fair market value) and other adjustments will be made for items that are non-recurring or non-representative of the future. An example could be an isolated event such as a lawsuit for a business that has never had a lawsuit before and does not anticipate having one in the near future. Past results are used as a basis for estimating future results.

For a business for which past results are not representative of what can be expected in the future, we must work with financial projections. In all the cases, we work with projections for the future. Either we take as a starting point the past results to estimate the future results, or we work with projections.

To estimate future results for an established business, we usually look at a five-year period. Why five years? To see the trend and stability of income and profits. Take the example of a business that made $ 600,000 in pre-tax profits five years ago, and made $ 100,000 less pre-tax profits per year for the following years to be left, in the last year, with a pre-tax profit of $ 100,000. The tendency of this business is to have a reduction of profits every year. All things being equal, we could expect that the business would not make any profits in the next year and would then incur losses in the following years. Would you be willing to acquire this business with this tendency assuming you don’t know how to straighten out the operating results? Probably not.

On the other hand, let’s take the example of a business that has been making more profits every year of the past five years. All other things being equal, this business would seem much more interesting than the previous one.

Another factor to consider is the stability of the growth of the income and profits and the level of uncertainty related to the estimates of future revenues or projections. The higher the level of uncertainty, the lower the value and vice versa.

A business owner works hard to achieve his goals and carry out his projects. When an owner decides to sell, it is justified to wish to obtain a reasonable value. For these reasons, a chartered business valuator (“CBV”) needs to consider all the elements at his disposal in order to determine the fair market value of the business he appraises. A CBV must be independent and objective when he expresses an opinion on the value of a business. The transactions carried out with the support of a CBV should therefore, be a win-win for both the seller and the buyer.

For support in the sale or purchase of a business, contact me!