A Basic Primer on Selling a Business: How do people value a business?

There are entire textbooks and reams of academic literature devoted to this topic (and rightfully so). But here we just want to summarise the basics for the un-initiated as briefly as possible, in simple terms. And the reason for doing so is that how a business gets valued is something that shapes both the structure and the content of business sale processes. In other words, to understand why business sale processes happen the way they do, one needs to understand the basics of how people approach business valuations.

This article is part of our multi-part series - A Basic Primer on Selling a Business. See the other parts of this series here.

In general terms, there are two main approaches to valuing businesses. And typically, but not always, a business valuation is worked up using both approaches (starting with the first, and then overlaying the second). We can label each approach and briefly summarise them as follows:

  • Discounted Cash Flow (or Discounted Earnings) valuation. This is the textbook approach to business valuation taught in business school Finance classes. In the “Discounted Cash Flow” (or “DCF”) approach, a detailed cash flow projection for the business is developed. Those cash flows are treated like an annuity of future cash payments, and the present value of that annuity is calculated by applying a discount rate to future payments. (The discounted earnings approach is conceptually the same, but instead of calculating the present value of future cash flows, it calculates the present value of future earnings (ie net income, as defined by the principles of accounting).)
  • Benchmarking according to industry-specific valuation metrics. Typically, in addition to the foregoing, a business valuation also considers how a proposed valuation of a business would sit according to specific metrics that are commonly referred to in judging business valuations in particular industry segments. The most common example of a so-called “metric” (which actually is considered across almost all industry segments) is the famous price/earnings multiple of the stock of a publicly-traded company (the ratio of its stock price to its earnings per share). But there are legions more metrics across various industry segments that finance professionals use to benchmark valuations of a business against industry peers. And for certain types of high-growth businesses (software businesses being a key example)–where future revenues, costs and cash flows may be quite difficult to forecast–these valuation metrics can actually serve as the primary basis for a business valuation.

Here is some more detail on each approach, in order to help us then think about how these approaches to business valuation shape why business sale processes are the way they are.

Discounted Cash Flow (or Discounted Earnings) Valuations

The key postulate underlying the discounted cash flow approach to valuation actually involves a significant irony: despite the fact that over time we have carefully developed accounting rules that strive to give a “true” picture of business performance (in particular by factoring in more than just cash transactions (eg things like depreciation and amortisation)), in the DCF approach one seeks to strip away the major accounting-based non-cash items that result in net earnings (on an accounting basis) and get back to simple cash flows! The proposed rationale for this is that accounting rules inherently involve management discretion in various respects (for example, in deciding over what lifetime the value of a piece of capital property should be depreciated or whether up-front expenses for certain types of business projects should be recognised when incurred or amortised over a period of time), so the goal is to get back to what is viewed as the more objective reality of simple cash flows. An alternative approach—the discounted earnings approach—sees cash flows as equally subject to management discretion (arguing that managers have plenty of discretion in setting the timing of cash receivables and payables, so cash flows are no more objectively reliable per se than earnings) and instead develops an accounting earnings-based valuation of the business, applying accounting policies and positions that the valuer itself thinks are fair and reasonable in order to develop a forecast of future earnings.

Regardless of whether a valuation is to be cash-flow or earning based, however, the conceptual approach is the same:

A projection is developed for cash-flows or net earnings over a forecast period. The longer that valuer can reliably forecast, the more confidence they can have in the resulting valuation. That forecast period is typically somewhere between 5 and 10 years.

The periodic cash flows (or earnings) in the forecast period are valued like an annuity of future payments, using a discount rate to calculate its present value today. The discount rate serves to factor in the element of risk that is involved in any payment in the future: $100 to be paid in one year’s time is not the same as having $100 in your hands today, because the payment due in one year’s time inherently is subject to some level of risk of non-payment.

There is all kinds of academic and practitioner debate about what specific sources to rely on when determining discount rates, but conceptually the approach to the discount rate is always the same.

The starting point for the discount rate is some estimation of a so-called risk-free interest rate: the interest rate an investor would expect to receive when making a loan where the repayments would be certain to be received (ie “risk-free”). The closest thing we have in finance to market estimates of risk-free interest rates are the market rates on the safest government bonds.

Since the cash flows from businesses are not risk-free, to develop an appropriate discount rate for calculating present values, we then add a second thing to the risk-free rate: an additional element of interest appropriate to the riskiness of the cash flows involved (a risk premium). So the resulting discount rate will be higher, the more there is risk involved in whether future payments will happen or not.

For the time period after the (typically 5 to 10 year) forecast period, one makes an assumption about the future growth rate of cash flows (or earnings) and values that future payment stream as a perpetuity that starts at the end of the forecast period. Then one uses the discount rate to calculate the present value of that future perpetuity. This second piece of the value of the business is called the “terminal value”. Not surprisingly, people pay careful attention to the assumptions used to calculate the terminal value, as well as to what proportion of the total business value it ends up representing.

Note also that when building a valuation model for a potential business acquisition, an acquirer that already has operations in the industry will typically also prepare a second version of their bottom-up valuation in which they factor into their cash-flow or earnings forecast the possible efficiencies achievable when the target business is combined with the acquirer’s. These efficiencies are usually referred to as “synergies” and represent cost savings (for example, combining HR staff such that the total of HR expenses post-acquisition can be less than the combined status quo in each standalone business) or revenue boosts (such as potential growth in the target business’ sales that could be achieved by selling its products also through the acquirer’s existing sales channels).

Benchmarking According to Industry-Specific Metrics

As mentioned above, there are legions and legions of financial metrics in different industries and industry segments that people refer to for valuation benchmarking purposes. People who invest in the stock market will be familiar with the practice of considering the price-earnings multiple of a stock (and will see that the ranges of such multiples vary from industry to industry, depending on perceived growth prospects for the industry). In the world of valuing private companies, it is common across all kinds of industries to look at EBITDA (earnings before interest, taxes, depreciation and amortisation) or EBIT multiples (ie. the valuation of a business expressed as a multiple of its EBITDA or EBIT). And within segments within an industry, there will also be a plethora of financial metrics that people look at, specific to the activities in that type of business.

For our purposes, there are two important things to realise about this aspect of business valuation. First, it is always a factor in how people look at an estimated valuation of a business. Typically valuers start with a bottom-up DCF valuation, then refine their output by benchmarking it against industry valuation metrics. And secondly, in some situations, the valuation metric benchmarks are actually the primary driver of valuation (typically high-growth businesses for which detailed bottom-up cash flow or earnings forecasting is sufficiently speculative that broader valuation comparison metrics give a higher order of clarity). An example is the valuation of early-stage software businesses, where for example in a “software as a service” business (in which customers license the software on a rolling basis as an ongoing business service) a key metric will be the sales multiple (valuation expressed as a multiple of gross revenues) and expectations for the appropriate range for that multiple will be shaped by other metrics like annual recurring revenue, customer retention rates and revenue growth rates.

So how is all this relevant to the process of selling a business?

Any business school Finance professor who teaches the subject will tell you that valuation is more of an art than a science. But they will also simultaneously point out that this does not make it meaningless. Rather than coming up with a wholly arbitrary valuation, the valuation methodologies of the world of Finance provide frameworks for trying to think consistently about valuation and for benchmarking valuations across comparable businesses.

And what is the relevance of all this to the practicalities of selling a business? It’s absolutely critical, because it shows a) that business valuation is based on making assumptions and projections about the future, and about the risk level in a business; b) that historical financial statements are an important report on business performance, but they are not forward-looking, they represent a summary of business reality rather than reality itself, and they do not speak to risk level in a business; and these two realities in turn show us c) that the key work in selling a business successfully (which is about helping a buyer make predictions of future business operations and understand risk levels in the business) is the work of explaining business operations, contingencies and risks…a very large amount of which is laid out in the terms of the business’s contracts. Historical financial statements are of course of central importance (valuations for a business with a history of dud profitability will usually not be great), but successfully selling a business for an optimal valuation is an exercise in preparing and organising the communication of an immense amount of information about commercial relationships—with much of that key information coming from the business’s contracts (as well as its internal analyses and operational reporting).

Continue reading our multi-part series:
A Basic Primer on Selling A Business