Valuation Basics: Earnings, Growth, Risk

Key Takeaways:

  • There are three fundamental drivers of a business’s value to a potential buyer.
  • A compelling valuation considers all three so you can understand where you stand today, pinpoint your value gap, and plot a path to exit.

Understanding the value of your business is critical, especially when you’re planning for the next phase — be it to merge, sell, raise capital, or even simply to convert the organization from C-Corp status to S-Corp status for tax purposes. Naturally, we pay most attention to the first two. After all, entrepreneurs and their advisors use Value Scout to understand their business value today, pinpoint the gap between where they are now and where they need to be to retire and execute value creation strategies to grow that gap over time.

In such situations, potential investors usually ask you to provide a clear picture of every aspect of your business. Also, you need to highlight the value points of your business to attract better investments.

Similarly, while developing an exit strategy, determining the minimum sales price for your business is the first step. However, is just having a specific number in your mind good enough? What are the odds that you may not meet your goals? You need to understand those things as well.

Business Valuation with Value Scout

Ideally, companies should get a business valuation done at least five to seven years before considering an exit.

The process for determining the value of a company that trades on the stock exchange is comparatively straightforward. But the same is not valid for privately held companies. This is where Value Scout comes in.

Business valuation is not merely about numbers, formulas, financial statements, and rates of return. It involves not just quantitative assessment but also qualitative analysis of a company.

While there can be many value drivers for any company based on the industry they’re in, the three fundamental variables that drive valuation most frequently are:

  • Earnings
  • Growth
  • Risk

Let’s take a quick look into each of these three fundamental variables that drive valuation and the factors that impact them:

#1 – Earnings

Sustainable earnings drive value for a business. While public companies adhere to regular fillings of earnings reports for shareholders as per Securities and Exchange Commission (SEC) requirements, private companies are not bound to any reporting requirements.

This makes an in-depth analysis of your business earnings crucial. The historical earnings trend speaks volumes on how your business is faring and helps in projecting future earnings.

The process involves a thorough study of your crucial business documents including, company tax returns, historical profit & loss statements, year-end balance sheets, profit and loss statements for the last twelve months, current year-to-date profit and loss statement, and current balance sheet.

Value Scout identifies the assets and liabilities of your company and compares it to other similar organizations in terms of profitability, liquidity, activity, etc. We determine the financial condition of your company and check if all the financial controls are in place.

Ultimately, earnings is a simple yet powerful variable that helps an external investor identify your current business value as well as assess future expectations after you’re long gone.

#2 – Growth

The second factor that truly determines value is growth. An organization that can demonstrate a track record of sustained growth (revenue and earnings), all things being equal, is more valuable than a static one.

Ultimately, the people in an organization first and foremost bring expert knowledge, relevant skills, deep experience, and unmatched creative abilities that drive growth. Valuation experts need to identify personal dependencies in your organization, the rights of the shareholders, study your management structure, and check your management succession plans to gauge prospects for future growth.

A company’s marketing and branding success play a vital role in its growth. A valuation should examine your company’s capabilities for sales and marketing, as well as the effectiveness of your brand, website, and social media presence.

Strategic planning significantly impacts the growth of a business. Business valuation is not just about the past and present. It is more about the future. Even if you are planning to sell, you need to show the prospects for your business to the new owner.

Suppose you want to go for expansion or merge, you still need a long-term strategy, a vision, and a roadmap to achieve your goals. A valuation should analyze your management’s long-term outlook, assess the latest business plan, and check if the company’s strategy meets your customers’ needs and expectations.

#3 – Risk

Ultimately, a buyer is purchasing a future stream of earnings. Yes, buyers want to see a strong track record of earnings and growth. But, lots of potential risk to the stability of those earnings inevitably drives down value. Buyers want confidence that those earnings and past growth can continue after you leave.

An important aspect that impacts business risk is the customer base. Let’s consider the example of a company relying on its biggest clients, who are very few, for most business earnings. What do you think is the risk in this situation for this company? The company stands the risk of losing a significant source of revenues, and buyers will discount the value of a company with that type of risk. A company having a stable and diversified customer base is more risk-averse.

The extent of an organization’s access to capital also determines business risk. An effective business valuation process for small and medium-sized private companies includes in-depth research into how the company is leveraged, how banking restrictions impact its current and plans, and much more. It also determines if involving a prospective investor is a viable option.

Another factor impacting risk in any business is the market environment in which it operates. Value Scout examines your company’s position in the market, a clear understanding of the niche by the management, and the diversity of offerings that can modulate the impact of economic swings.

While focusing on a niche is a strength for companies, it can also increase the risk of dependence on limited markets. Diversification reduces this risk, improves value, and facilitates growth. Going by this strategy, Value Scout assesses your company’s mix of offerings, their vulnerability to industry and economic swings, opportunities for diversification as well as integration.

One final element of risk is research and development (R&D). Often, small companies lack sufficient resources for R&D and cannot keep pace with the increasing technological changes in the market. This often creates downside risk for the buyer.

To understand this, Value Scout analyzes the status of your technology and how it impacts the current and future offerings of your company. We also examine your R&D processes as well as resource allocation for the same.

Related: Three Value Levers: Earnings, Growth, Risk

Final Thoughts:

Ultimately, a company’s value is just a number. It’s an assessment of the company’s worth based on three core dimensions of value – Earnings, Growth, and Risk. Value Scout can help you understand where your company falls on all three sizes so you can understand your business value today. Then, it enables you to plot your path to future value, assign people and tasks to make it happen, and assess your likelihood of success along each dimension.

Author Summary:
Matt Lawver

Matt Lawver

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