Business owners are inevitably faced with the question of what their business is worth. Whether this information is needed to establish a selling price, secure financing or simply plan for the future, a business’s value is on the mind of every owner. Interestingly, there may be many different perceptions of a company’s value, with the starkest differences coming from anyone looking to sell a business and anyone looking to buy it. While there will always be some subjectivity involved in establishing a company’s value, the one factor central to any evaluation is earnings.
A company’s earnings, especially earnings before interest, taxes, depreciation and amortization (EBITDA), is typically where the valuation process starts. A multiple is then applied to EBITDA to establish the company’s overall value. It is the development of this multiple that is the key to a fair and proper valuation.
There are many factors that go into developing the EBITDA multiple, and here are just a few:
Customers. Customers certainly affect a company’s value, especially the type and mix of customers. Long-standing relationships with reputable clients will positively impact a company’s value, and customers in growth industries are viewed more positively in the long term than those in mature or declining industries. A wide customer mix (many different customers, with none having too-large a percentage of overall sales) is also a positive factor. In fact, companies that have a limited number of customers, each representing a large percentage of overall sales, may be perceived as having a risky customer base. Ultimately, the value assigned to a company’s customers will be based on those it
will have in the future rather than those it had in the past.
Position in a market. A company’s position in a market, whether it is local, national or international, also has a bearing on its value. A market leader is likely to have a higher value, yet a company’s rate of growth or decline in a market will also be a factor. For example, a relatively small market share can be viewed positively if the company has shown sustained growth, while a large market share might be viewed negatively if the share has been steadily eroding.
Products and services. Products and services offered can also impact value. New products and services may provide greater sales potential in the future, while mature products, although likely a major reason for past sales, may be at the end of their life cycle and unable to offer much in the way of sales growth. A company with an obvious lack of any new products or services could be viewed as lacking innovation and take a hit on its valuation. As with customers, the right mix of products and services is important. If a majority of sales comes from one or two products or services, there is more risk than if a wide variety of products contributes equitably.
Assets. A company with a great deal of new, updated equipment may have a higher value, especially if the equipment has demonstrated productivity or quality improvements. Buildings, land, solar panels and other energy-efficient and cost-saving systems can also increase a company’s value.
Technology. How a company develops or utilizes technology can go a long way in increasing value. Likewise, patents and other forms of intellectual property give the impression that the company has something unique to offer, thereby providing a competitive advantage that can help to sustain future success.
Management team. An experienced, skilled management team also can increase a company’s value. Of course, any positives associated with the management team can only last as long as the team remains intact. A skilled, dedicated team that shows no interest in working at a company if it is sold may not be viewed favorably, especially if the skills of the team are seen as a major reason for the company’s success. It is said, “As goes the management team, so goes the fortunes of the company.”
Extraordinary actions that affect EBITDA. Sometimes in the course of doing business, owners take actions that directly impact EBITDA. For example, during slow periods, the owner and even some managers may take a reduction in salary. In doing so, expenses are temporarily reduced, so earnings are inflated. One-time sales bumps, such as an accelerated sale made just before the end of a fiscal year (instead of throughout the next fiscal year), can also increase earnings. Other atypical actions also can reduce earnings, such as a one-time expense for supplies or equipment, or hiring temporary workers. To account for these actions, the EBITDA should be re-evaluated and extraordinary actions, although perfectly legitimate, isolated.
The ultimate value of a company, of course, is the amount for which it is sold. However, understanding some of the factors that affect its value can increase your knowledge of what that amount should ultimately be.