Three most common small business valuation model categories
Part one
Valuating your business is crucial. Valuating your business before you think you really need to evaluate it is even better. However, many business owners only start to contemplate a valuation process in the midst of a divorce, corporate breakup or a selling process. Unfortunately, this makes you miss the bigger picture. Valuating your business will allow you to see how far you’ve come and benchmark against yourself for future reference, but it will also give you a snapshot of where you are today. After all, most of us are in business in order to create value – makes sense to know your own value then, right?
A masterpiece and a work-in-progress at the same time
Valuation models today are both a science and an art. It is both magnificently accurate and abstract, intriguing and complex at the same time. There are several different types of valuation models. They all come with their own set of advantages, alongside their disadvantages. In textbooks and research papers, it is generally established that all models would give the same results if applied consistently and without any restraints. However, since most models today include a forecast of the future, the models are applied with some limitations. The limitations will decrease the level of accuracy in varying ways, depending on model. We’ve selected the three most common business valuation model categories and will discuss the implications of all of them. Enjoy!
Direct cash flow models
As the name gives away, this model is based on the cash flow that is leaving or coming into the company. They can be both direct and indirect, i.e. the models focus directly on the cash flows to the shareholders or indirectly on the cash flows generated by the company from an operating perspective. Consequently, it includes models based on discounting of dividends to the shareholders of the company, but this only highlights how the funds are being distributed, not the value being created. The target here is on cash flow model’s focus on cash generation. The most commonly known indirect cash flow model is the free cash flow model. It’s useful when you want a view over your current cash generation status from your operations which is the key in value creation. Theoretically, this is the core of most models, but in practice it is tough. Cash flows often vary a lot over time, making them difficult to forecast.
Relative valuation models
Relative valuation models are based on comparisons with other businesses in the same industry. By looking at similar companies and their valuations, these models try to analyze your business in relation to others. Relative methods can then illustrate if a business is over- or undervalued compared to similar enterprises. However, more times than not, it is quite dangerous to assume that the market has it figured out. It can be argued that it was the lack of critical thinking that led us into the 2008 financial crisis, or into the Greek crisis in 2011. Sometimes the market values an entire industry inaccurately, and we find it best to be aware of those risks. Nonetheless, we are here to discuss the model. In order to make a good valuation, the key ratios that are compared should be broadly equal to the other companies. This is why you should be careful of which ratios you choose. Earnings measures that are defined in the same way across companies is a good place to start! But again, the limitation is found in the market itself. Since the economy changes over time, an industry’s key figures from last year can be misleading when analyzing a company today.
The best is yet to come
Stay tuned for more! The next post will contain part two of this mini-series, where we will discuss the third business valuation model category. We will also let you know which explicit model we think is the most applicable, and why!