When it comes to your firm’s value, do you have a number in mind for what you think it is worth? The truth is there is no one true value of a company; it depends on a variety of factors including the purpose and use of the valuation.
When most business owners think of value, they think of Fair Market Value (FMV). By definition, FMV is the price at which property would change hands between a willing buyer and a willing seller, when neither party is under pressure to transact and both parties have reasonable knowledge of all relevant facts. However, determining FMV is not as cut and dry as it would seem. There are a variety of different methods for determining FMV. While a valuation indicating FMV may be necessary for purposes of transactions, such as internal stock trading, some business owners engage in valuation exercises on a regular basis to ensure that the investments they are making in their business are moving the needle in the right direction. After all, what gets measured improves.
FMV valuation methods
Valuation is a complex field, and the appropriate methodology will depend on the specific asset or situation. Consulting with financial professionals or valuation experts is the best approach to make an informed strategic decision.
- Market approach: This method is based on the principles of competition and equilibrium. The market approach estimates the value of a target business by comparing it to similar assets that have recently been sold in the open market. This approach assumes that the market price of similar assets reflects their fair market value.
- Income approach: Based on the principles of anticipation, the income approach estimates the value of an asset or business based on its ability to generate income in the future. This approach is commonly used for businesses and investments that generate cash flow.
- Cost approach: This approach estimates the value of an asset by assessing the cost to replace or reproduce it. This method is particularly relevant for valuing assets that do not have an active market or when the cost of replacing the asset is a significant factor in its value.
Each of these approaches relies on varying factors, such as financial projections, or market-derived data and may not be suitable for all asset types.
Investment value – M&A value
In mergers and acquisitions (M&A), FMV is not what determines valuation. The negotiation between buyer and seller determines what the value will be and often includes unique synergies which are specific to each combination of buyer and seller. From a thirty-thousand-foot view there are two main factors that buyers look at when determining value: benefits stream and risk.
The benefit stream will be determined by how the seller fits into the buyer’s overall strategy and what the seller brings to the table. Risk comes into play as any elements that will impact the benefits stream for the buyer. The greater the benefits stream, the greater the value. The greater the risk, the lesser the value.
The benefits stream is primarily driven by pro forma earnings or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) which is essentially operating cash flow. A company’s actual results are the starting point in building a pro forma and most often will be the result of a recent trailing twelve-month period. Adjustments are then made based on how things would look under the construct of a buyer to arrive at pro forma EBITDA which represents the benefit stream.
Drivers of value
Most likely, improving the value of your business is an ongoing objective, but what specific things drive value? There are a variety of factors that will influence value and the perceived risk factors including:
- Expertise: Do you have specific expertise that the buyer currently doesn’t have or that would be difficult for the buyer to replicate?
- Perpetuation preparedness: Do you have the next generation of leadership identified or does the existing management team have 10+ years of runway?
- Historical growth rate: What is your historical organic growth? Have you been able to generate new business and grow organically outside of rate increases?
- Historical profitability: Are you able to generate sufficient profit or are your expenses out of line?
- Concentrations: Do you have any significant concentrations that could increase the risk factor around accounts, carriers, producers, industry, etc.?
- Size: Larger firms typically command higher multiples as they have more scale and capacity that the buyer can leverage.
For most independent business owners, the largest asset in their portfolio is tied to shares in their own company, but they do not have a clear view on valuation. It is easy for business owners to get caught up in the day-to-day operations of their business, but it is important to take a step back and think about what your firm is currently worth and what you hope it will be worth in the future. Understanding your starting point is key to successfully charting a path forward.
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