Given that many Finweek and ValuationUp.com 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 it coming in the next months.
We started this column with 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 financial 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 finance 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 firm, and (c) returning money to shareholders in the form of dividends or share buy-backs if the firm 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 financial information through regular management accounts and audited financials. Reliable data allows rational decision-making.
When valuing a business we try 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 3 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 the stream of expected economic benefits (profit after tax, cash-flows, 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 SMB’s (due to a lack of direct comparables, low trading volumes and dubious financial 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: “2 firms in the same industry with identical financial statements can face very different futures, and thus have very different valuations.” Only the income approach using a Discounted Cash Flow valuation can measure the impact of the ‘different futures’ to show which of these two firms is more valuable. The other approaches would value them the same, which is obviously a falsehood.
In SMBs, calculating cash flows requires some adjustments (e.g. adding back discretionary spending, excess owners compensation, dealing with once-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 firm 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 financial 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 cash flow forecast. To do that, we need to understand the cash-flow 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 5 years into the future). The question then becomes which discount rate to use, and in the last few articles we’ve unpacked the core concepts of the firms Weighted Average Cost of Capital.
Through this journey, hopefully you’ve understood that as an entrepreneur you need to do a regular DCF valuation of your business to set future 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 finance (a) what projects should be invest in that increase the value of the firm? And (c) when should we declare dividends or buy back shares?
Remember to ask for help if anything here has confused you: @valuationup