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SELLING A BUSINESS

The Math Behind Your Company Valuation

What you need to know to increase the value of your business for a financial buyer
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Have you ever wondered what a business like yours would sell for?

It's a fair question, but focusing on your valuation is a little bit like a hypertensive person focusing on his or her blood pressure report. To really understand the number–and to move it up or down–you have to understand the calculation.

Financial buyers (I'll save strategic buyers for another column) acquiring a company will usually do some math to figure out what they are willing to pay today for the rights to your business's future profits.

We've all made a similar calculation. For example, you may have decided in the past to invest $100 in a bond that offers 5 percent interest per year; that is, you decided to spend $100 on something that would be worth $105 a year later.

To see how this math affects the value of your business, imagine you have a company that you expect to generate $100,000 in pre-tax profit next year. Buyers looking for a 15 percent return on their money in one year would pay $86,957 ($100,000 divided by 1.15) today for $100,000 a year from now.

When valuing a business, financial buyers will typically value not only the next year's profit, but all expected profits in the foreseeable future. For every year into the future that buyers must wait to get their profits, they will "discount" the future profit you are projecting by the rate of return they expect.

For example, if you project your company will generate $100,000 of profit per year for the next 10 years (sort of a silly example because no company generates exactly $100,000 a year for ten straight years and then nothing in the eleventh year but I'll use it for simplicity), financial buyers would "discount" the $100,000 by 15 percent for each year they have to wait for their money:

End of year

Pre-tax profit

15% discount

1

$100,000

$86,957

2

$100,000

$75,614

3

$100,000

$65,752

4

$100,000

$57,175

5

$100,000

$49,718

6

$100,000

$43,233

7

$100,000

$37,594

8

$100,000

$32,690

9

$100,000

$28,426

10

$100,000

$24,719

Net present value

 

$501,878

Therefore, an investor looking for a 15 percent return on his or her money would pay $501,878 (in MBA parlance, this is called "net present value") today for a business that he or she expects to generate $100,000 a year for the next 10 years.

The price an investor is willing to pay for an asset relates to how risky he or she perceives the future stream of profits to be: the riskier the investment, the higher the return an investor will demand. Today, investors can put their money into relatively safe bonds and get a few percentage points of return, or they can buy a balanced portfolio of big-company stocks and expect perhaps a seven or eight percent return over time.

But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money. For illustrative purposes, imagine an investor is looking for a 50 percent return for buying your business because he or she deems your future stream of profits to be very risky (or the likelihood of you meeting the targets very uncertain). The following table illustrates the effect a 50 percent discount rate has on the value of a business projecting $100,000 in profits per year:

End of year

Pre-tax profit

50% discount

1

$100,000

$66,667

2

$100,000

$44,444

3

$100,000

$29,630

4

$100,000

$19,753

5

$100,000

$13,169

6

$100,000

$8,779

7

$100,000

$5,853

8

$100,000

$3,902

9

$100,000

$2,601

10

$100,000

$1,734

Net present value

 

$196,532

The same business projected to generate $100,000 for the next 10 years is worth less than half as much when, due to perceived risk, the investor demands a return of 50 percent instead of 15 percent.

To understand the relationship between growth potential and value, imagine that, instead of generating a flat $100,000 in profit for the next 10 years, you expect profits to grow by 20 percent each year in the future. The table below illustrates how a financial buyer, looking for a 15 percent return on his or her investment, might value this company.

End of year

  Pre-tax profit growing at 20% per year

15% discount

1

$120,000

$104,348

2

$144,000

$108,885

3

$172,800

$113,619

4

$207,360

$118,559

5

$248,832

$123,714

6

$298,598

$129,092

7

$358,318

$134,705

8

$429,982

$140,562

9

$515,978

$146,673

10

$619,174

$153,050

Net present value

 

$1,273,207

Note that the only change between this example and the one using a 15 percent return on investment is the projected growth rate. The business expecting a 20 percent growth rate over the next 10 years is worth more than double the business that expects its revenue to remain flat.

In the end, as a business owner, you have three levers to manipulate in order to increase the value of your business for a financial buyer: how much profit you expect to make in the future, the rate of growth of your profit each year, and the degree of risk associated with your future profit stream.

Last updated: Sep 7, 2011

JOHN WARRILLOW | Columnist | Sellability

John Warrillow is the author of Built to Sell: Creating a Business That Can Thrive Without You and the founder of The Sellability Score, a cloud-based software company that helps business owners improve the value of their company.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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