Lessons to apply to business valuations

By Bakley Smith, CFA

Most business owners – especially those in the startup space – have an eye on valuation. At what level does the market value the company? The media, of course, feeds the frenzy with television shows, articles, podcasts and a steady stream of click bait, aimed at illuminating the opaque world of valuation.

Your writer spent ten years valuing companies in the public sector and did work on several IPOs and secondary offers in the those markets. Nevertheless, valuing growing companies remains an elusive and difficult task. Here are four lessons for those wishing to value a business.

Beware the Comps

A lot of people value assets based on comparable assets or “comps.” This is a useful but flawed technique. There was a familiar conversation in 2004-06 where neighbors would find out what a house in the area sold for, peg the supposed value of their house off what their neighbor sold his or hers for and conclude that their house was worth $X.

This works until it doesn’t work, and this type of thinking, which went all the way to the “top” of the financial pyramid, was a major contributor to the financial crisis that followed. Unfortunately, the impulse to peg values, as discussed in this excellent book, rather than derive them is too strong, and many still use comparable assets as the main driver of valuation.

All underlying valuation is related to future cash flow and risk. Anything other than that is market timing and not based in the practice of valuation. To accurately ascribe a value to a company, a manager must first project cash flows into the future. The next steps require ascribing a multiple to those cash flows, using discounted cash flow or a “market” multiple which can lead back to comps.

Focus on EBITDA

Staying hooked to EBITDA is a good way to stay out of trouble and find real values in the market. Most seasoned and talented investors look for EBITDA, which is an acronym for what the company makes from its operations; it excludes non-operational concerns such as taxes and capital structure.

Staying honed in on the company’s EBITDA allows the manager to stay true to what investors really want. Presenting performance based only on sales can give the impression that all the manager is interested in is sales, which should turn most good investors off. Sales do not carry the day, but cash flow does.

Implied in venture investors’ desire for scaleability is the profitable operation of the company’s core system. They want a reasonable process by which $1.00 turns into $1.50 by running through the company’s operating structure. EBITDA keeps the focus on the whole process whereas sales can be temporarily impacted by unprofitable investments and unsustainable operations.

As Bob Morrison of Quaker Oats once said, “You want volume (growth)? I’ll show you growth; I’ll sell cereal for $1 a box.” Growth can be bought. Profit must be earned.

In 2015 Growth Cures All

Most companies continue to operate in a low-growth environment. Investors face negative interest rates around the world and are compelled to seek returns on their money. This has put a major premium on growth businesses and is reflected in high valuations for many private startups. This focus on growth currently looks likely to continue, although either a downturn in the economy or an increase in inflation could impact the situation.

For now, growth is king and companies that show a clear growth path are likely to be valued at a premium valuation to others.

Profits Always Win

As noted elsewhere, sales growth is great, but it can be acquired for the right price. In the end, profits win out. The question for both companies and investors is “What does in the end mean?” The answer is different to different people. Generally speaking, an owner could sacrifice some level of profit in pursuit of growth in 2015 and see valuation improve. The best managers will achieve growth while exercising discipline around profit so that when the environment changes, they can adopt.

About the Author. Bakley Smith, CFA is the founder of Lead Agency, a service that connects top businesses with strategic, marketing and financial resources. He resides in New York City with his wife. Read his Blog