Past performance is not an indicator of future results!On the Startup Coach group on Facebook, I was asked how a business should be valued. It was acknowledged there that the method of valuing a business is not very scientific. I'm now going to try to tackle this area in plain English...
Valuation is an art, not a science
Unfortunately, most accountants, bankers and business advisors resort to a rather naive rule of thumb when considering the value of a business. It goes something along the lines of:
Multiply the average of the last three years profit by 3.
So, that's great. I'm going to buy Amazon for about a fiver.
Some apply a little more science to it:
Adjust the weighting of the previous profits so that more recent performance is weighted higher than older performance. Find a comparable P/E ratio from the Financial Times, then arbitrarily half it because that's what we've always done.
Then multiply this more complicated average by a more complicated multiple.
Slightly better - at least it takes into account some realities, and may be a rough approximation to start thinking about, but doesn't address a fundamental point. I could still probably buy Amazon for a fiver...
Past Performance is not an indicator of Future Results
We've all heard this several times in relation to investments! And what is a business purchase...?
Very simply, when a business is being purchased, a purchaser is buying two things:
- Assets (the stuff the business owns less what it owes - fairly self explanatory); and
- The trade of the business
The valuation is therefore a combination of the two.
How should you value the trade?
Ultimately, you need to place a value on tomorrows performance, today. There are a number of tools that can help you perform this, such as discounted cash flows, IRR, payback periods etc... The description of each is beyond the "plain English" scope of this post, but broadly - you need to be looking at the value of tomorrows profit, not yesterdays.
What else needs to be taken into account?
As we know, numbers don't tell the whole story.
You need to consider a range of things, which might include:
- market opportunities
- external threats in the political, economic, technology or social arenas
- inherent risks in the business and the industry
- intangible assets generated within the prior trade, but not recognised on the balance sheet
- security of contracted future income
- strength and retention of the management team
- motivations on both sides
It's not just a case of multiplying yesterdays profit by 3.
So, what is the right value?
As a general rule of thumb, if both sides are uncomfortable but happy to sign, you've probably reached the right valuation!