The Fascination With Asset Valuation: From Collectibles to Businesses
People have long enjoyed tracking the value of assets, from baseball cards, to cars, to art, to stamps, to antiques, and beyond. Whether driven by a desire to speculate, a passion for a collectible, or the elation of realizing an inherited antique might fetch the value of a small car, contemplating value is a favorite pastime. Thus, it should come as no surprise that business valuation is also a hotly followed topic. Look no further than the myriad of resources, calculators, and professional services offerings that a Google search for “business valuation” yields.
Rather than rehash valuation methods or offer insight into recent valuation trends, we’ll endeavor to impart insights into a thought process that we believe is useful for understanding valuation logic and attributes that create, or reduce, business value. By understanding these attributes, business owners can take steps to enhance value.
First, The Art of Valuation
Despite valuation’s technical association, the exercise of assigning value to something is as much art as it is science. Consider the philosophical question, what is anything worth? Is value equal to the price a buyer is willing to pay? Or is value equal to the price a seller is willing to accept? What about a scenario in which there is no overlap between the buyer’s number and the seller’s number? If the parties in a transaction can't agree on value, what is the asset in question worth?
If the high end of the buyer’s valuation does not overlap with the low end of the seller’s valuation, no transaction takes place. Thus, we arrive at the intersection of opinion and economics. Two opinions but no exchange of economic value. This lack of consensus between buyers and sellers is often referred to as a wide bid-ask spread, and suggests that a valuation, although held in the form of two opinions, has not been confirmed by a transaction. Without overlap on the Venn diagram of valuation expectations, a transaction won’t take place and a valuation won’t be authenticated.
Price Stability is a Sign of a Healthy Economy
Fortunately, we exist in a well-functioning economy with a narrow bid-ask spread for most products. In the United States, price stability is present across many routine transactions (groceries, restaurants, clothes, travel, etc). Accordingly, we have important benchmarks of value all around us in the form of comparable prices. When we encounter a good or service that appears to be priced high relative to similar products or services, we can simply walk away from the transaction and elect to transact with a lower cost merchant. Eventually, the high price merchant will either lower prices, make product changes to support a premium price, or face the consequences of a lack of sales.
Unlike routine retail transactions, business acquisitions take place far less frequently, and at a scale that is substantially larger than an average retail transaction. The complexities related to purchasing a car or a home are a step in the direction of the type of transaction a business purchase represents. As transaction size grows, so does the risk associated with the purchase and therefore the scrutiny that goes into valuation.
A Business is Valued Based on its Stream of Future Cash Flow
Famed investor Warren Buffett is notorious for stating that an important consideration when valuing a company is the discounted value of cash flows the business will produce “between now and judgment day.” In other words, how much cash will the business generate going forward, on what timeline, and at what level of risk (referred to as a discount rate)? Cash is defined as money available after all costs associated with a business are considered, whether for operating expenses, cost of goods, research, or the purchase of property, plant, and equipment required to sustain the revenue generating operations of the business.
One problem, we don’t know what will happen in the future, which means assigning a risk level to cash flow is challenging. The seller might believe the risk to future cash flows is low, which would warrant a low discount rate and a high valuation. The buyer may perceive the risk differently, assigning a higher discount rate than the seller and thus a lower valuation. This difference in risk assessment is the starting point for a wide bid-ask spread.
Consensus is Important in Business Transactions Too
When we engage in routine transactions, such as purchasing groceries or clothes, we can quickly compare prices across merchants to form a consensus of value. When we find a vendor with a suitable price, we make a purchase and authenticate the value of the good or service. Without this authentication, we have two opinions of value - the merchant's opinion and our opinion. But we lack any proof that there is a willing buyer and seller at a specific price.
Accordingly, we look for authentication of value in business transactions by observing recent transactions, usually transactions that have taken place within the past two or three years. These transactions offer important feedback on the price at which the buyer and seller agreed to transact. These prices, known as comparables, are used to set the benchmark for a consensus business valuation.
Two common forms of comparable valuations are those obtained from (1) public companies and (2) recent acquisitions. Public companies are highly liquid and are marked-to-market every day, which offers a real-time glimpse into the price at which buyers and sellers are willing to transact. Often, these prices are reflected as multiples of cash flow. In the figure below, the left column displays an example set of comparable public companies, and the right column displays an example set of comparable transactions that represent completed acquisitions.
The Consensus Informs the Discount Rate
When Buffet references cash flow discounting, he’s addressing the unique risk that a business faces during the course of ongoing operations. To quantify this risk one can use a discount rate, which is typically expressed as a percentage. Once a forecast of future cash flow is produced, the discount rate assigned to those cash flows will represent a risk adjusted present value of the cash flow. A higher discount rate will produce a lower present value of cash flows, and a lower discount rate will produce a higher present value of cash flows.
As an example of cash flow discount rates, consider a series of cash flows over seven years. In the hypothetical example below, the business generates $1,000 per year, for a total of $7,000 over the seven year period. When discounting the $7,000 to a present value using a 5% discount rate, we would value the stream of cash flows at $5,786. If we assume the risk to the cash flow is greater than 5%, say 15%, the present value declines to $4,160. Greater levels of risk lead to a higher discount rate, which produces a lower present value.
Unfortunately businesses don’t offer a clear indication of the appropriate discount rate to apply to a series of cash flows, so the market tends to rely on valuation multiples to inform the level of risk associated with a particular business. In the comparable companies and transactions example above, we see that public company comparables trade for a median of seven times cash flow. This multiple is effectively a discount rate, or a proxy for the required rate of return associated with investment in the business. To illustrate this point, divide 1 by the multiple to generate a discount rate (1 / 7X = 14%). An industry with a median cash flow multiple of six times implies a higher discount rate (1 / 6X = 17%), while a median cash flow multiple of eight times implies a lower discount rate (1 / 8X = 13%).
Deviations from Consensus in Business Valuation
The cash flow multiples of comparable companies and comparable transactions inform investors of the market's view of the discount rate that should be applied to an industry, or subset of businesses. It’s important to note that comparable companies and transactions represent a broad spectrum of businesses, and multiples should be analyzed to understand similarities to the business in question, or to ensure that items such as earnouts aren’t inflating multiples. Further to the point of accuracy, valuation multiples are frequently quoted against EBITDA, which has its own shortcomings as a proxy for cash flow. Taxes and capital expenditures are not represented by EBITDA but will impact the level of free cash produced by a business.
Just as we concluded that the price paid at a retailer represents an agreement of value between a seller and a buyer, the price paid for a business similarly represents an agreement of value that informs a discount rate on a particular type of business. By studying the median discount rate for a group of businesses, an individual business can be compared to the peer group to determine how the business shapes-up relative to peers.
When valuing a business, there are a number of considerations that lead to a deviation from the consensus. For instance, according to research published by the NYU Stern School of Business, private companies are valued at a discount to public companies due to lack of liquidity, with the discount ranging from 20% to 30%.
The size of a discount relative to the consensus may vary based on company size, the health of the economy, buyer type, interest rate environments, and other factors that impact the risk of a company’s future stream of cash flows. Below is a figure that illustrates a number of factors that may result in favorable, or unfavorable, deviations from consensus.
The certainty of cash flow can be positively or negatively impacted by a range of factors, including growth rates, size, competitive advantages, customer retention, key person risk, and other attributes that warrant a higher or lower discount rate relative to the consensus.
Will You Find Overlap on the Valuation Venn Diagram?
Valuation is a favorite topic of debate, regardless of whether for collectibles or businesses, but business valuation is particularly emotional for sellers and buyers given the levels of cash at risk. When going down the path of exploring business valuation, one can go through sophisticated exercises and pay tens of thousands of dollars for valuation analysis. But if a willing buyer does not exist at the valuation a seller has in mind, or if a willing seller doesn’t exist at the valuation a buyer has in mind, then a disconnect exists that will create a bid-ask spread that often results in a stalled deal process.
In an attempt to complete a business sale, owners should consider unique attributes of their business relative to a comparable set of businesses, and attempt to address any elements of the business that appear to create a negative deviation from the consensus valuation. Rather than landing on a specific value, it’s advisable to arrive at a range of valuations that would be acceptable based on the owner’s unique goals, and that reflect the risks to the future stream of cash flows.
