What is my business worth?
I am often asked by entrepreneurs, “how should my company be valued?” In this post, I do not give you a fish, nor do I teach you how to fish. I teach you how to decide whether to go fishing, hunting, or stay home and do some gardening. There are primers on valuation exercises everywhere. The goal of this post is to help you understand the "Why" behind the methodologies. Trust me, it's much more useful.
Many entrepreneurs use various valuation tools (our friends at adventure.es have a great one) or even engage professional CPA or valuation specialists to provide opinions. However, at the end of the day, if all the professional does is ask you for projections and pull some comp transactions based on your industry, you have been ripped off. The report is probably not worth much and will collect dust in your office.
Why is it worthless? Your business is unique. If it’s not, then it’s probably not even close to worth as much as the companies in the comps. If it is unique, it’s probably not worth what the companies in the comps traded for either. I suggest you focus on two things: (1) cash flow and (2) moat (click the underlined terms for definitions).
Cash Flow
Your business is worth a discounted future value of the cash flows (DCF) it will generate. Period. People who say “my business is worth so much more than the dollars it produces,” should be willing to accept something other than dollars as consideration for purchase. But alas, they aren’t. No matter how special or “strategic” your business is, eventually that specialness should turn into cold hard cash on a repeated basis.
Now, your projections are not necessarily the best way to forecast this piece. The reason is simple: if you can predict further into the future than you can create value, you have a problem. You cannot know how much revenue and EBITDA your company will produce in 2027. That said, there are attributes of your business that can suggest the length of time and amount of upside you have in your future.
Moat
In 1997, Michael Mauboussin and Paul Johnson set out to quantify the drivers behind stock market returns. If asset values, management forecasts, and cost of capital can only explain so much, what other elements of value could there be in a business? (Note: cost of capital is basically its interest rates on debt and the lowest return equity investors will accept to stay in the company). Enter Competitive Advantage Period, or “CAP.”
The general economic theory of CAP is as follows: due to competition, a company’s return on assets will equal its cost of capital in the long run. Why? Because as others perceive a company’s ability to generate great returns, be it through margins, technology, efficiencies, etc., competitors will enter the market and accept slightly lower returns until all the excess returns are competed away. Thus, a company will only outperform its cost of capital for a period.
Companies can raise their CAP through innovation and developing competitive moats. Here is a great chart from venture capitalist Gerry Neumann highlighting several moats.
How do I put this to use?
I’ll leave the academic nuances and forensic exercises to Mauboussin and colleagues. Their paper is fantastic and worth reading over and over. At the end of the day, however, comp transactions and discounted cash flow are two means to the same end, and they are limited in their usefulness as academic ways to value your business. Mauboussin hates EBITDA multiples because it is based on an arbitrary accounting measure that is limited to profitability on your Profit and Loss, but fails to account for how much of your EBITDA actually turns into cash after things like capex and working capital.
In the real world, however, EBITDA when combined with capital expenditures and information related to how quickly the company turns its short term assets into cash (cash conversion cycle), you can get close.
Here is the punch line: your DCF and your EBITDA multiple should come to the same answer. If your business is truly special, it has competitive advantages that point to long term cash flow that generates returns in excess of the cost of capital. The closer EBITDA is to real cash flow (hint: run a business that generates lots of cash left over for investing in those aforementioned moats), the better. Also, the better those moats, the higher the multiple. Easy peasy.
