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 flow generation) discounted by the amount of risk to the capital employed in the business.
A business sources capital from equity investors and by borrowing money (debt) from lenders like banks, so in valuation calculations we discount future cash flows 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 multiplied by its 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 – they only get paid once everyone else has been paid.
So what this means is that the cost of equity capital is highest because its 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.
So how do you calculate the cost of Equity capital?
It’s not easy. Even for big listed companies, you need to look at how the business tracks the index, the index tracks the market, the market tracks the global economy and then relate this all back to long-term treasury bond interest rates in the USA. There are fancy words we use in Finance like Beta and synthetic Beta, and a whole bunch of 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 limited really to large funds and experienced investors.
So 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 that uses it, but also allows a bigger fund or investor to compare risk and costs of equity across several businesses, even those that operate in different industries around the world.
So what we’ve developed is a survey tool. We call it the ‘Business Attractiveness Survey’ because it’s about the future and strategy as well as being about risk. The survey takes about 15 minutes to complete, is dead easy for a business owner to do, and the results are entirely 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 go to www.valuationup.com, register, add your business and start answering the questions. Your results are confidential (others you add in your business will see them, outsiders wont). 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 opportunities. We’ll share interesting information here and in our blog 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.