Business owners considering an exit often want to know who their likely buyers will be and how much money those buyers are willing to pay. In order to forecast a realistic sale price, owners often look to standard metrics such as the ‘multiple of earnings’ – a valuation theory based on the idea that similar assets sell at similar prices. This way of thinking often leads business owners to the quick conclusion that the easiest way to increase their business value is to increase the earnings of the business. This newsletter examines that basic concept and challenges this conventional thinking by first asking the question, “Does the industry that you are in have the largest impact on the value of your business?”
Value is a Prophesy of Future Cash Flow
The most important concept in valuation is the idea that a future buyer for your business will pay you for the cash that they expect to generate from your business in the future. A prospective buyer will only write you a check for your business if they are confident that there is a ‘future’ for your company. The price and terms a buyer will pay are driven by the riskiness of the future, as they perceive it. There are three (3) important items to consider:
- Increased profitability will generally drive your company value higher.
- Reduced risk in your business will also drive your value higher.
- The industry in which you exist will produce willing investors who can best evaluate the risks of future cash flows.
In reality, in order for an owner to monetize their illiquid business, they need a buyer or investor willing to pay them for their future cash flows. Additionally, the industry the owner is tied to is one of the leading indicators of value, as it will determine how investors perceive the industry and are willing to invest in the future of that industry.