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| Target Search Group |
Have
you ever wondered what a business like yours would
sell for? Ultimately, it’s what a willing and informed buyer is willing to pay
for it.
Focusing
on your valuation is a little bit like a hypertensive person focusing on his or
her blood pressure. To really understand the number–and how to move
it–you have to understand the calculation.
Financial buyers acquiring a company will usually do some calculations to determine what they are willing to pay today for the rights to your business's future profits.
An example of a similar calculation is when someone invests $100 in a bond that offers 5 percent interest per year. That $100 spend would be worth $105 a year later.
To see how this math affects the value of your business, imagine you have a company that is expected to generate $100,000 in pre-tax profit next year. Buyers looking for a 15 percent return on their money in one year would pay $86,957 ($100,000 divided by 1.15) today for $100,000 a year from now.
When valuing a business, financial buyers will typically value not only the next year's profit, but all expected profits in the foreseeable future. For every year into the future that buyers must wait to get their profits, they will "discount" the future profit you are projecting by the rate of return they expect.
For a simple example, if you project your company will generate $100,000 of profit per year for the next 10 years and then nothing in the eleventh year, financial buyers would "discount" the $100,000 by 15 percent for each year they have to wait for their money:
End of year
|
Pre-tax profit
|
15% discount
|
1
|
$100,000
|
$86,957
|
2
|
$100,000
|
$75,614
|
3
|
$100,000
|
$65,752
|
4
|
$100,000
|
$57,175
|
5
|
$100,000
|
$49,718
|
6
|
$100,000
|
$43,233
|
7
|
$100,000
|
$37,594
|
8
|
$100,000
|
$32,690
|
9
|
$100,000
|
$28,426
|
10
|
$100,000
|
$24,719
|
Net present value
|
$501,878
|
Therefore,
an investor looking for a 15 percent return on his or her money would pay
$501,878 (in "net present value") today for a business that he or she
expects to generate $100,000 a year for the next 10 years.
The
price an investor is willing to pay for an asset relates to how risky he or she
perceives the future stream of profits to be: the riskier the investment, the
higher the return investors will demand. Today, investors can put their money
into relatively safe bonds and get a few percentage points of return, or they
can buy a balanced portfolio of big-company stocks and expect perhaps a seven
or eight percent return over time.
But
when buying one relatively risky business rather than a balanced portfolio,
investors will expect a much higher return on their money. For illustrative
purposes, imagine an investor is looking for a 50 percent return for buying
your business because he or she deems your future stream of profits to be very
risky (or the likelihood of you meeting the targets very uncertain). The
following table illustrates the effect a 50 percent discount rate has on the
value of a business projecting $100,000 in profits per year:
- $100,000 - $66,667
- $100,000 - $44,444
- $100,000 - $29,630
- $100,000 - $19,753
- $100,000 - $13,169
- $100,000 - $8,779
- $100,000 - $5,853
- $100,000 - $3,902
- $100,000 - $2,601
- $100,000 - $1,734
Net present value $196,532
The
same business projected to generate $100,000 for the next 10 years is worth
less than half as much when, due to perceived risk, the investor demands a return
of 50 percent instead of 15 percent.
To
understand the relationship between growth potential and value, imagine that,
instead of generating a flat $100,000 in profit for the next 10 years, you
expect profits to grow by 20 percent each year in the future. The table below
illustrates how a financial buyer, looking for a 15 percent return on his or
her investment, might value this company.
| End of year | Pre-tax profit growing at 20% per year | 15% discount |
| 1 | $120,000 | $104,348 |
| 2 | $144,000 | $108,885 |
| 3 | $172,800 | $113,619 |
| 4 | $207,360 | $118,559 |
| 5 | $248,832 | $123,714 |
| 6 | $298,598 | $129,092 |
| 7 | $358,318 | $134,705 |
| 8 | $429,982 | $140,562 |
| 9 | $515,978 | $146,673 |
| 10 | $619,174 | $153,050 |
| Net present value | $1,273,207 |
Note
that the only change between this example and the one using a 15 percent return
on investment is the projected growth rate. The business expecting a 20 percent
growth rate over the next 10 years is worth more than double the business that
expects its revenue to remain flat.
In
the end, as a business owner, you have three levers to manipulate in order to
increase the value of your business for a financial buyer:
- How much profit
you expect to make in the future
- The rate of growth
of your profit each year
- The degree of risk
associated with your future profit stream
Mr. Stidham is a Sales, Marketing and Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment. He has served as the head of business development and sales for entrepreneurial organizations as well as Fortune 500 companies. His experience includes companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.
Mr. Stidham speaks the language of both the seller and the buyer having vast experience working on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of private and corporate transactions. Mr. Stidham provides guidance to businesses on improving their sales and operational efficiencies leading to increased revenues and earnings.
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