Business Value, It's All About Future Return and Risk!

Value is the expression of the worth of something. It can be measured in different ways. Some things may have sentimental value but little financial value. Many businesses have sentimental value, but when business value is discussed it should be focused on financial value.

Business value is future oriented.
Last year’s earnings of the business are valuable to a prospective buyer only to the extent they give some indication of future earnings. This is often the case but should not be assumed too readily. Businesses are always changing. Customers and employees come and go. Contracts expire and may not be renewed. Technology is changing most industries.

The future business earnings and cash flow potential from a group of assets is what a prospective business buyer is purchasing. That is the only financial benefit they will get.

Business value is about getting a return on an investment.
Return is the anticipated future cash flow from an investment to an investor. It is the cash flow that will be available to them to be considered a return on their investment and not consumed by the business for capital expenditures or working capital. Quantifying what is often referred to as future net free cash flow to invested capital and discounting it back to present day value is critical to arriving at an accurate business valuation.
One of the first due diligence procedures a sophisticated business buyer will perform is to ask management for their projections of the next few years’ business operations in the form of financial projections. This is the first step in quantifying future expected cash flows. If they are not available prospective buyers may work with management to create them based on the best available information and assumptions.

From the sellers prospective it is best to have these available before engaging in discussions with potential buyers.

Business Value is a Function of Risk
Risk is the essential variable used to quantify the fair market value (present value) of future cash flows to an investor. Risk measures the uncertainty that the future net cash flows will be received. Without consideration for risk every dollar of future return, no matter how speculative, would be equally attractive. Increased uncertainty in future cash flows will increase risk and reduce business value. Reducing future uncertainty will increase business value.

Quantified risk in the form of a desired rate of return can range from the return on a 10 year U.S. treasury security, normally considered the risk free rate of return, to high rates of return with numerous risk premiums required on highly speculative investments. Quantifying the risk of future cash flows from a business in the form of a required rate of return requires substantial insight, business knowledge and judgment.

So, business valuation is really very simple. Just measure the future cash flows and convert them to present value using a discount rate (expected rate of return) that fairly measures the risk involved.