What we’ve learned so far

Finweek English Edition - - BUSINESS - Re­mem­ber to ask for help if any­thing here has con­fused you: fin­week@val­u­a­tionup.com.

Gi ven t hat many Fin­week read­ers will be read­ing this edi­tion just be­fore the start of the De­cem­ber hol­i­days, we thought it would be use­ful to re-cap what we’ve learned so far, and set the scene for what’s coming i n t he next months.

We started this col­umn by point­ing out that en­tre­pre­neur­ial fail­ure rates are very high, and that for en­trepreneurs who get past the cru­cial first year or two, the big­gest cause of fail­ure is a “lack of f inan­cial un­der­stand­ing of the busi­ness by the en­tre­pre­neur”. Our in­ten­tion is to make a ma­te­rial im­pact on success rates by in­creas­ing the level of un­der­stand­ing of f inance by en­trepreneurs. “Cor­po­rate fi­nance” as a dis­ci­pline tries to max­imise the value of the firm by (a) in­vest­ing in as­sets that earn a re­turn above its hur­dle rate, (b) op­ti­mis­ing the mix of debt and eq­uity to fund the f irm, and (c) re­turn­ing money to share­hold­ers in the form of div­i­dends or share buy­backs if the f irm can’t suc­ceed at (a). The abil­ity to do this de­pends on treat­ing your busi­ness like any other unemo­tional in­vest­ment and also on hav­ing sound f inan­cial in­for­ma­tion through reg­u­lar man­age­ment ac­counts and au­dited f i nan­cials. Re­li­able data a l l ows ra­tio­nal de­ci­sion-mak­ing.

When valu­ing a busi­ness we tr y to de­ter­mine “the price, ex­pressed in terms of cash equiv­a­lents, at which prop­erty would change hands be­tween a hy­po­thet­i­cal will­ing and able buyer and a hy­po­thet­i­cal will­ing and able seller, act­ing at arm’s length in an open and un­re­stricted mar­ket, when nei­ther is un­der com­pul­sion to buy or sell and when both have rea­son­able knowl­edge of the rel­e­vant facts”. This is called its fair mar­ket value (FMV). So how do we ac­tu­ally mea­sure the value of a busi­ness? There are three broad ap­proaches: The as­set ap­proach, which mea­sures the value as “as­sets net of li­a­bil­i­ties”, the mar­ket ap­proach, which com­pares the busi­ness to other re­cent trans­ac­tions of a sim­i­lar na­ture, and the in­come ap­proach, which at­tempts to mea­sure value by con­vert­ing t he stream of ex­pected eco­nomic ben­e­fits (prof it af­ter ta x, cash-f lows, or div­i­dends) into a sin­gle present-day amount.

We de­bunked the worth of the as­set ap­proach (ex­cept in liq­ui­da­tion), and of the mar­ket ap­proach – al­most never worth­while for SMBs (due to a lack of di­rect com­pa­ra­bles, low trad­ing vol­umes and du­bi­ous f inan­cial info).

The in­come ap­proach re­quires some un­der­stand­ing of ba­sic maths and the abil­ity to ques­tion the fu­ture of the busi­ness. How­ever, it’s the only method that pro­duces a us­able re­sult. If you are still not con­vinced, then think through this state­ment: “two firms in the same in­dus­try with iden­ti­cal f inan­cial state­ments can face very dif­fer­ent fu­tures, and thus have very dif­fer­ent val­u­a­tions”. Only the in­come ap­proach us­ing a dis­counted cash f low val­u­a­tion can mea­sure the im­pact of the “dif­fer­ent fu­tures” to show which one of th­ese two f irms is more valu­able. The other ap­proaches would value them the same, which is ob­vi­ously a false­hood.

In SMBs, ca lcu­lat­ing cash f l ow re­quires some ad­just­ments (eg adding back dis­cre­tionary spend­ing, ex­cess own­ers com­pen­sa­tion, deal­ing with one-off losses or gains, non-op­er­at­ing ex­penses, and pe­ri­odic losses or gains). Th­ese ad­just­ments re­quire some care and ob­jec­tiv­ity. Costs that are rea­son­able to the seller are not to the buyer, both need ex­ter­nal ad­vice and sharp pen­cils.

To help use the his­tory of the f irm to check as­sump­tions made about its fu­ture, we in­tro­duced the con­cepts of com­pound an­nual growth rates (CAGR) – by which you can quickly see how much a line item has changed over sev­eral f inan­cial pe­ri­ods and “er­ror-check” pro­jected growth rates. We showed how to use the “sum of

years” dig­its method to give re­li­able weight­ings to the val­ues from dif­fer­ent pre­ced­ing years.

Fore­cast­ing growth is al­ways tricky and I’ve no doubt that if you put all the en­trepreneurs’ fore­casts to­gether we’d see eco­nomic growth of sev­eral mul­ti­ples of na­tional GDP over the next few years. The trick is to be scep­ti­cal of any claims over 10% growth; most SMBs op­er­ate in very com­pet­i­tive mar­kets where growth is far but as­sured.

Once we have un­der­stood our costs struc­tures and our growth rates, we’re ready to pull that to­gether into a cash­flow forecast. To do that, we need to un­der­stand the cash-f low for­mula then sim­ply pull the num­bers across (again, early for­mu­las are in prior ar­ti­cles and also even­tu­ally reach blog.val­u­a­tionup.com).

With a cash flow forecast in hand, we in­tro­duced the con­cepts of dis­count­ing back to present value, in­clud­ing how to cal­cu­late the ter­mi­nal value of the DCF (the value of the firm for all years be­yond five years into the fu­ture). The ques­tion then be­comes which dis­count rate to use, a nd in t he last few ar­ti­cles we’ve un­packed the core con­cepts of the firms weighted av­er­age cost of cap­i­tal.

Through t his j our­ney, hopefully you’ve un­der­stood that as an en­tre­pre­neur you need to do a reg­u­lar DCF val­u­a­tion of your busi­ness to set f uture tar­gets. Then you need to man­age your cap­i­tal struc­ture and cost of cap­i­tal closely so that you max­imise this val­u­a­tion. This is one of the core things that big com­pa­nies do which SMBs don’t, and it’s not too hard.

Now that we have un­der­stood what drives val­u­a­tion and the cost of cap­i­tal, we can turn our at­ten­tion to an­swer­ing the other core ques­tions in cor­po­rate f inance (a) what projects should be in­vested in that in­crease the value of the firm? And (c) when should we de­clare div­i­dends or buy back shares?

By Gareth Ochse

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