Measures like Price-Earnings Ratio and EBITDA multiples are just gross generalizations of the value of your business. Here's how to determine the real value.
Estimating the value of your business is usually calculated through measures such as earnings, EBITDA, and “comp” multiples. But if you’re trying to maximize the value of your business, the most accurate metric is customer value. Specifically, the value of your business is best measured by the aggregate value of your customers.
Finance theory tells us that the value of your business is equivalent to future cash flows, discounted back to today at the cost of capital. This is true. But how do most bankers, valuation experts, and business owners arrive at this valuation? They typically take the most recent year’s cash flows, or an average of the prior few years’, and project them into the future.
This is simplified further by use of “multiples,” or a multiple of current year cash flows used to approximate the present value of future cash flows. Since cash flow varies greatly from year to year at most businesses, EBITDA (earnings before interest, taxes, depreciation, and amortization) is often used as a more stable proxy for operating cash flow.
But as a CEO or business owner, you don’t need this level of accounting precision to value your business. You understand that your business is worthless if customers are not willing to pay (and continue to pay) for your product or service. Fortunately, you can use this concept to calculate the value your business. Here is the basic concept:
Calculate the lifetime value (or more specifically, the estimated future cash flow) of each of your customers or customer segments. Follow the methodology we outlined in our recent article.
Estimate the value of entering new customer relationships or customer segments, then discount the figure by a large factor, say 20 percent, to adjust for the probability of success.
Add the value of each customer or segment, including the discounted value of potential new customers.
For most businesses, this figure will closely approximate the value of your business. For high-growth businesses, where current year cash flows are not a driver of future cash flow potential, this may be a better methodology. Surely, Facebook and Groupon are not being valued in the financial markets based on current year cash flows. Instead, analysts are calculating the potential value that their current and future customer base could create.
More importantly, valuing your business based on the value of customers is actionable. As a management team, it’s easy to see how to improve the value of the business by improving the value of your customer base. This calculation helps get you there.
KARL STARK AND BILL STEWART are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree. @karlstark