Anybody can Google the definition of business value: “the value of a business today is the present value of future economic benefits.” That is straightforward if you are a business appraiser, but for the average business advisor or owner, business valuation can feel like a black box. However, it does not have to be that way. Let’s take a look inside.
This definition points out there are two key elements to business valuation–future cash flows (economic benefits) and calculating the present value of these cash flows. In earlier blogs, we’ve covered the role of cash flows in business valuation. Now we can consider the present value portion of the equation, which requires an understanding of rate of return and discount rates.
Let’s start with a familiar scenario. If you have $1000 to invest and you get a 10% rate of return, in a year you will have $1100. The calculation of present value is simply the reverse of this. If you’re projecting, or expecting, to get $1100 one year from now, what amount would you be willing to accept if you could receive payment today rather than waiting one year?
When valuing a business the buyer actually builds projections of expected cash flows and then needs to determine what they would be willing to pay today for the opportunity to earn those cash flows in the future. A discount rate, or expected rate of return, is needed to convert these future expected cash flows into today’s dollars.
The key is to thoroughly understand the subject business, including all the qualitative and quantitative risks and opportunities, in order to determine the appropriate discount rate that is specific to that company. There are five components to this discount rate, which we will explain next month. Many times, this area of valuation is what can lead to such significant differences in value conclusions. Suffice to say, this is where the experience, independence and judgment of the appraiser is vitally important.
More key concepts of business valuation are explained in an understandable way in our ebook, “An Introduction to Business Valuation”. Download your copy here.
Whether you want to understand the overall landscape of business valuation or have a specific question for a client you are working with, we’re here to help.
Cathy J. Durham
Cathy Durham: Cathy Durham is a past president of Capital Valuation Group Inc., which has been specializing in business valuation and litigation support services for over 50 years. If you'd like to discuss your unique business or client's business situation, please click on our link for a complimentary call with our team.
