How do I value my company, a client recently asked me. The client’s company has been in the red, losing money for years, but a buyer is still interested. Many of the entrepreneurs have been asking the same question: how does one figure out the value of a business? For a famous example, how did Jollibee come up with a P3 billion price for a 70 percent stake in Mang Inasal way back in 2010?
I knew of entrepreneurs looking for investors but had no idea how much percentage stake they were supposed to give for the amount of money they desired. There are also many business owners who are already expecting to retire on the funds generated by the sale of their businesses. Since they do not know how much their business is worth, they are apprehensive that they might be pursuing a pretty risky retirement strategy.
Given the importance of business value to strategic planning, one would imagine that every business owner already knows the value of his business. However, I’ve found that this isn’t always the case. In fact, since business owners are so close to their businesses and know how much hard work, time and money went into building them up, they are often naturally inclined to over-inflate the values.
There are a lot of reasons to get a business valuation. In an article, Grant Thornton has opined that, given the current economic realities, privately held businesses (mostly dynamic companies in the small and medium-sized categories) in all sectors are looking for ways to strengthen their performance, and a valuation might just be the best starting point. Getting to the value is important, but what many often overlook is the strategic advantage in understanding your “value drivers.” In other words, it’s essential for business owners to understand the factors that enhance the business value so they can focus on these metrics to drive their growth.
Determining a business value is as much an art as a science. Fundamentally, the value of a business lies in its ability to generate future cash flow. One of the most common places to start is an income-based approach; i.e., estimating the expected future cash flows and then taking a hard look at the risks to determine an appropriate discount or capitalization rate.
This kind of approach looks at the company’s business fundamentals and how the company derives its economic benefits and when such benefits can be earned. Since the economic benefits are expected to be derived in the future, there is an element of risk that has to be factored in, usually in the form of either a capitalization rate or a discount rate.
Another method is the asset-based approach, which means adding up the values of the underlying assets (minus all liabilities) of the business. The basic premise is that if one has to engage in a similar existing business venture, one has to acquire all the assets and, in the process, incur liabilities. The challenge in this approach is the valuation of the assets and liabilities, especially since there are “intangibles” in a company’s business that might not be captured in the statement of financial position or balance sheet. An “intangible” can be an exceptional client service or the effective execution of their strategy.
A market-based approach, which compares a business with others within the same industry, is also commonly used. This approach looks at a recent sale or purchase transaction of a similar business, with an adjustment to the rates given certain intrinsic values of the business. This is where market forces come in, as we have to look at the price a buyer is willing to pay and which a seller is willing to accept. However, for privately held businesses, this can be difficult. Some companies use a valuation formula to simplify the process, but this can often be inaccurate or overly restrictive.
Once you’ve run all these numbers, you also have to take into account some more intangible factors, such as the changing industry, market trends, or the impact of management structures. And then, of course, there are brand strength, customer and supplier relationships, name recognition, patents and trademarks, and proprietary technology, just to name a few.
Once you’ve done all these, you have the magic number—or do you? While value tends to fall within a range, there is never just one value for a business. Buyers will determine their own value—one of the reasons why there are often differences between the “notional value” and the street value when it’s actually put up for sale.
So, what’s the bottom line? Don’t wait until you’re ready to sell to get a valuation. Understand the business value today (mainly the business drivers) so that you can plan for growth tomorrow. Who knows, you might be the next Mang Inasal.
Jessie Carpio is a partner and head of BPS/Outsourcing. He is also the president of P&A Grant Thornton Outsourcing Inc., an entity wholly owned by P&A Grant Thornton. P&A Grant Thornton is one of the leading Audit, Tax, Advisory, and Outsourcing firms in the Philippines, with 21 Partners and over 800 staff members.
As published in Manila Times, dated 15 February 2017