Over a year ago we started this column with the idea of helping entrepreneurs understand more about what drives value in a business and how to influence this so as to build a more valuable business.
To recap, the value of a business today is based on its expected future returns (free cash-f low generation) discounted by the amount of risk to the capital employed.
A business sources capital from equity investors and by borrowing money (debt) from lenders like banks, so in valuation calculations we discount future cash f lows by the weighted average cost of capital (WACC). This is the after tax cost of debt multiplied by its proportion of capital employed, added to the cost of equity mult ipl ied by it s proportion of capital employed.
Generally, any debt is secured against an asset and is repaid from profits before tax. Then taxes are paid and only afterwards does any surplus get passed on to the equity investors.
Likewise, if the business runs into trouble and is liquidated, the equity investors are the last to get any money out.
So, what this means is that the cost of equity capital is highest because it’s at the greatest risk. The cost of debt is the amount your commercial bank charges you on loans longer than a year. It’s easy to calculate – just read your bank statement. relate this all back to long-term Treasury bond interest rates in the US. There are fancy words we use in finance, like ‘ beta’ and ‘synthetic beta’, and mathematical formulas used to calculate them.
What’s hard to get right in big listed companies becomes impractical in the SMB market, so for SMBs the approach taken is one of two – either the equity investor says: “I need a return of at least 30% in my fund, so let me discount by that amount and see if the number remains positive,” or the private investor says: “Given what I know about the risk of the business, I want a return of 20% on my money, so let me discount by that amount and see if the number is positive.” In both cases, these are very subjective numbers, whose practical application is really limited to large funds and experienced investors.
How can you determine the appropriate cost of equity capital for your business?
Well, over the past 16 months we’ve been working on scoring risks in a business and trying to come up with an appropriate cost of equity that you can use in valuations. We’ve been looking for a way to do this that offers not only a reliable estimate for any SMB, but also allows a bigger fund or investor to compare risk and costs of equity across several businesses, even those operating in different countries.
What we’ve developed is a survey tool. We call it the ‘Future Outlook Survey’ because it’s about the future and strategy as well as about risk. The survey takes about 15 minutes to complete, is dead easy, and you’ll be able to access the results for free. The results include an overall risk score for your business (compared to its industry peers) and a suggested cost of equity capital that you can use in your own valuation calculations/investment decisions.
All you need to do is register on www. valuationup.com, add your business and answer the questions. Your results are conf idential. If you invite others from your industry – your customers and suppliers, even your competitors – you’ll get to see how your risk compares to the industry average (and how your suggested cost of equity compares to the industry average).
Over time, we hope to build up a zeitgeist of each industry in each country, including commentary from business owners around specific risks, trends or opport u nit i e s . We’ l l s ha r e i ntere s t i ng information as it becomes available.
How risky is your business? What returns should you be looking for on your equity capital given this risk? Where should you focus efforts to lower risk and increase your valuation? Find out for free on ValuationUp.com.
Gareth Ochse is founder of ValuationUp. com – a financial analysis and strategy tool that shows how a business is being run, what it’s worth, what it could be worth and how to get it there. Email email@example.com with any feedback/questions.