Valuation: What is it? & Why is it Important?

By Tom Cramer

Sports serve as a frequent metaphor for business, and that concept is particularly relevant in one key aspect. In the final analysis, it is all about the points on the board. It is not about trying or effort or intention, it is about the balance sheet and the valuation your business will support. These are the concrete metrics that reflect the end results of all your efforts as a founder and as a manager.

Providing a Baseline

Most business owners and managers understand what a balance sheet is from a technical, accounting perspective. However, far too few see that balance sheet as a useful tool for directing the activities of their business. Even fewer take advantage of a regular evaluation as an effective measure of their success.

The concept of a business valuation is utilized to measure the transferable value of assets and the enterprise as it exists at a given point in time. The valuation incorporates many objective elements and metrics, such as the balance sheet. It also assigns subjective values to a variety of business elements. For example, we discussed earlier the idea of Intellectual Property as a component of a company’s value.

We also discussed earlier exit strategies. That is where valuations play a central role in determining what options you and/or your business may have when it comes time (planned or otherwise) to leave the venture.

How are Valuations Calculated?

The process of arriving at a valuation for a non-public company is a combination of art and science. The “hard” objective factors will include:

• Cash Flow
• Assets
• Profitability

Even these numbers, however, will be sifted to determine trends and future prospects based on those trends. Then, additional subjective factors will include:

• Risk factors for the market, the company, and the macroeconomic picture
• Management structure, strengths, and weaknesses
• Many additional “due diligence” factors
• The motivation for and purpose of the valuation

This latter factor comes into play when a company is being acquired, sold, or is seeking significant new equity funding. The motivations of the two participants (buyer/seller, lender/debtor, company/investor) will play a major role in negotiating the elements of due diligence to determine a mutually acceptable valuation.

There are at least two dozen “accepted” valuation methods, but most agree there are three basic components. These include 1) assets (fair market and/or replacement cost), 2) income (some form of discounted free cash and/or residual) and 3) market components (comparables and precedents for segment enterprises). The various methods all assign different weights for these components and then arrive at a “final number” that is justified by those assumptions and inputs, along with negotiated conclusions.

Why Do I Need a Valuation?

One myth concerning valuations is that they are only necessary when an event such as a sale or merger is contemplated. As noted above, those trigger events will revolve around a valuation determined by rigorous due diligence and analysis, combined with serious negotiations.

At the same time, regular internal or third-party valuations without such trigger events are an important consideration. They add a significant dimension by which you can gauge your success beyond the retained earnings line of that balance sheet. It is a powerful yardstick you can use to gauge the ultimate return on your investment of assets, time, and other resources.

The advantages of consistent and realistic valuations provide management with:

• An important insight into the effective estate and exit strategy planning
• Essential information that facilitates access to capital and proper leveraging of your
  capital structure
• Benchmarks for internal performance and competitive comparisons
• A core “KPI” for gauging overall success in achieving performance goals
• Guidance on where to allocate resources to increase returns and eliminate drags on
  performance

Valuations serve a multitude of purposes for management. The decision to incorporate valuations into your management toolbox does not have to add a major expense. Depending on your size and where your business is in its life cycle, you can conduct one internally using available guides and templates. On the other hand, there are a handful of reliable and respected third-party specialists in the field who are used when the valuation is used for a sale, merger, or other significant corporate events.

Take time to consider how a periodic valuation will provide valuable and actionable insights you
might otherwise miss.