Business Valuation: How Much Is a Business Really Worth?
The true value of any business is the sum of all the cash you receive from the business now and in the future. Business valuation involves answering two questions: "how much?" and "when?" These questions are the same for any business you may buy or engage in: from a lemonade stand to the Coca-Cola Company.
If you knew how much cash would be returned and exactly when it would be received, you'd be able to nail the business value with accuracy. But life isn't so simple. You must piece together the "how much" and "when" from what you know, and what can be inferred, about the business and its value as a business.
Business value is created and driven by the following factors:
- Income: Profits — revenues in excess of costs — are the starting point. More important are the cash flows, especially free cash flows generated by the profits. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money.
- Income growth: Steady income with no growth over time is valuable, and a business with steady income is worth paying for. But without growth, the value of future earnings depreciates over time. There's little to make a stock price rise in this instance unless the market values the income stream incorrectly in the first place. So income growth becomes a key driver of business value.
- Productive capital investments: It's important that a company be able to invest additional capital productively — at a greater return than it would get by putting that capital in the bank. And it goes without saying that a company should invest capital more productively than you can; otherwise, it makes sense for you to invest your capital elsewhere.
- Rising productivity and falling expenses: A good business makes progressively better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner per unit of capital deployed than other less productive businesses.
- Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate (which reduces value) or margin of safety because you just don't know.
- Steady or rising asset values: Asset growth, particularly current assets, should ultimately lead to higher shareholder returns. If assets (for example, cash) aren't distributed directly to shareholders, the company may become a more attractive takeover target. Since an eventual takeover also pays you cash or some other consideration that can be converted to cash, like stock of the acquiring company, a business with high or growing takeover value is more valuable.
- Favorable intangibles: Many internal and external phenomena can affect or serve as leading indicators of business value. By nature, items like management effectiveness, brand franchises, intellectual property, and unique skills and competencies are hard to quantify, but they are very much a part of the valuation playing field.