Theory and the real world

Do you want to buy a business, but don't know what to pay for it? Or, do you already own a business and want to know its value? This article may bring you closer to answering these questions. I will give you a different perspective from which to understand business valuation. In the process, I will show you two ways to quickly value a business without having to hire an appraiser. The methods I show you will give you back-of-the-envelope answers that you should not rely upon for serious concerns such as an actual sale of a business, and valuing a business for estate planning or litigation purposes. For situations like these consider hiring an accredited business appraiser.

To understand how to value a business you must know that two forces in business valuation are at constant war with each other. One force is theory; the other force is the real world. Theory has the brains because it knows the true value of a business. The real world has the power because businesses are bought and sold in the real world at real world prices.

In the late 1990s a classic battle between theory and the real world emerged when dot- com businesses became popular. Theory said the dot-com businesses were not valuable. The real world said the dot-com businesses were extremely valuable. Investors listened to the real world. The real world is powerful because it looks at recent sales of similar businesses. Investors paid millions of dollars for dot-com businesses because every other dot-com business was selling for millions of dollars too. It was like lemmings following each other off a cliff. This is the driving force behind real world valuation - guideline transactions.

Guideline transactions are recent sales of similar businesses. This reasoning states that a business will sell for the same multiple for which a similar business has already sold. If a dot-com flower business sold last week for a price equal to 10 times its revenue, then a similar dot com flower business should also be worth 10 times its revenue. In this example the multiple is 10, and it is based upon sales price divided by revenue.

A quick way to figure out the value of your business today is to use guideline transactions. Find recent sales of businesses similar to yours. Similar businesses will be approximately the same size as your business and have the same operating characteristics. For example, after looking at guideline transactions you find a business similar to yours that generated $2 million of revenue over the last twelve months, and sold yesterday for $6 million. You would find the revenue multiple by dividing $6 million by $2 million. The resulting multiple is three. You would then take a look at your business, which generated $1.5 million of revenue over the last 12 months. Multiply your $1.5 million of revenue by the number three. This yields $4.5 million, which is what the real world says your business is worth. Theory may not agree with this price, but the real world does not care.

During the dot-com frenzy it was obvious to my professors (in the late 1990s I was in graduate school) that the real world was paying way too much money for the dot-com businesses. My professors believed this because they listened to theory. Theory states that the value of any business is a result of the future free cash flow the business is expected to produce. Free cash flow is the cash left over after a business has made all necessary expenses to keep it a going concern.

Cash not needed by the business is the owners(s) return on their investment.

My professors were laughing because a popular internet toy company had a higher real-world value than Toys 'R' Us. This internet toy company was not producing cash flow; it was consuming cash flow. A mature business like Toys 'R' Us can keep itself alive by producing cash flow from operations (i.e. the sale of toys). The internet toy company did not make sufficient cash from the sale of toys. In order to stay alive it was consuming all of its cash flow from operations plus it consumed cash from its owners. Despite this, the real world was convinced that the internet toy company was more valuable than Toys 'R' Us. For over a year my professors thought this was the funniest thing they had seen in a long time.

Theory values a business by examining the free cash flow it produces. This reasoning states that when a person buys a business, they are really just exchanging a lump of money today for a stream of free cash flow tomorrow.

The problem with theory is that it is very hard to implement correctly. And, if you do implement it correctly, you will still be filled with doubt because the real world will probably tell you the business is worth something else.

A quick way to figure out what theory says a business is worth is to calculate the free cash flow you expect a business to generate next year. You can then divide that free cash flow by the return you feel is appropriate. Higher risk would require you to ask for a higher return. For example, you determine that a business will make $200,000 of free cash flow next year. You then decide that the business is moderately risky, so you feel comfortable with a 20 percent return on your purchase. The next step would be to divide $200,000 by 20 percent (or 0.20). The result is a purchase price of $1 million. If you felt the business was in the high risk category you would demand a 40 percent return for the same free cash flow. Dividing $200,000 by 40 percent (or 0.40) yields a purchase price of $500,000.

Value investors like Warren Buffet are very good at understanding theory. Value investors find businesses that produce free cash flow, but are disliked by the real world. When theory says a business is worth $15 million but the real world says that business is worth $10 million, a value investor gets excited. They get excited because they can buy a $15 million business for only $10 million. However, after they buy the business their next course of action is to wait. Value investors know that the real world eventually agrees with theory, but it takes time.

In the early 2000s the real world finally agreed with theory regarding the value of dot-com businesses. Most dot-com businesses were not producing free cash flow, and they did not have any chance of producing free cash flow in the future. Once the real world realized this, dot-com valuations came crashing down. The internet toy company that once had a market capitalization higher than Toys 'R' Us lost so much value that it was de-listed from its stock exchange. My professors felt vindicated.

Even though my professors finally had proof that they were correct about the true value of dot-com businesses, they missed an opportunity to make a lot of money. Consequently, they are still teaching. One person I know who took advantage of the dot-com craze is now a retired millionaire. The challenge with business valuation is that it is more of an art than a science. The question of right versus wrong has little merit. A more important question asks who has the most money at the end of the day. Theory is always right, but it is weak. The real world is sometimes wrong, but it dictates the price for which a business will sell.

When you hire a business appraiser the appraiser will value your business as of a certain measurement date because business valuations are constantly changing. Your business appraiser will employ valuation techniques based upon theory, the real world, and other techniques not covered in this article. The result will be an unbiased estimate of value supported by information that was known or knowable as of the measurement date.

John Langley is senior analyst specializing in business appraisals for Meridian Business Advisors. Contact him at 954-2020 or jlangley@mbareno.com.