Jeremy Gray – Show 11 Season 4. How to determine the value of anything?
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What’s it worth? What is the return on my investment? Which is the better choice of my investment dollars? How many times have you asked yourself these questions? Fortunately there are ways of calculating the answer to these questions and many more; we will explore them during this show.
Oscar Wilde said a cynic is someone who knows the price of everything and the value of nothing, It is important that investment decisions not only be based on numbers but also reflect your values.
Behind every investment decision a company makes there should be a calculation of what that move is worth. Whether the decision is to launch a new product, enter a strategic partnership, invest in R&D, or build a new facility, there should be an understanding of whether the investment will add to the company’s profitability or not. Different projects are competing for the same scarce resources of capital and people, Optimizing the allocation of resources, in turn, is a key driver of a company’s overall performance. It is possible for an investment decision be negative to a company’s profitability but positive to the company’s overall earnings.
Clients often ask “How much is my company worth?”. This will be covered during the show.
Show Objectives - The Why
Businesses need a way to decide which investment decision is the most appropriate for them. The driver will depend on your company. Is cash flow most important? Then a project with lower upfront investment but lower returns may be the most appropriate. Is the speed of payback key? i.e. the time to recoup your investment most critical? I need my investment back as fast as possible so I can use the returned funds for my next business expansion. Or are you looking for the highest return or ROI?
Tax considerations may also play a role. Are there often tax incentives for investment that can sway investment decisions. Had a great year and facing a huge tax bill? Governments often incentivize investment in research or overseas expansion which can greatly reduce the required investment in a project that might take longer to see returns but is a worthwhile investment for the future of your business.
The power of spreadsheets means that you can use several valuation methods to assess what is optimum for your business.
Key Issues - Owner Perspective:
Why as an owner should you take the time to understand the detail behind valuations techniques? To learn which methodology is the right one to use for the project under discussion? To understand why different valuation models will give different answers. The answer is because as the owner you have so much vested in the investment decision than anyone else in your company. You will bear the brunt of any consequences of a poor decision, equally you will gain the most from selecting the right investment.
All valuation techniques rely on forecasts. Even methods that seem to based on “fact”. For example one valuation method for your business in called the multiple of earnings valuation. That is where the value of your business is the EBITDA times a multiple that buyers may be willing to pay. That multiple is a forecast. Depending on the business circumstances that multiple can change. You are estimating or forecasting the likely number. Another valuation method for a business is the book value method where the balance sheet is used as a basis for valuation. But it is almost certain that some assets on your balance sheet are not valued correctly. If you own land and buildings they are probably undervalued on your balance sheet. If you vehicles that are new they will be overvalued on your balance sheet. You need to adjust your balance sheet to forecast the value of the assets at today’s prices.
Net all valuation techniques rely on forecasts and as the owner the business you need to assess the accuracy of the forecast. A small change in the forecast can make a huge difference in the valuation. Adjusting sales growth from 5% to 7% will be significant over a five year or longer period. By understanding how assumptions impact your chosen valuation technique(s) you will be able to improve the model and thus your investment decision.
Plus you need to ensure that the investment decision matches your values which may mean you give more weight to one criteria over another. If you understand the models being use the more certain you can be that this is being achieved.
What You Need to Know - The What or Other Considerations
Not often discussed when talking about valuation models but managing risk can be an important part of your model.
For example suppose you are going to launch a new product when you do not currently have the required equipment.
There may be 3 alternatives open to you.
You can also use your model to determine when to switch for one selection to another. At what volume does it make sense to move from toll manufacturing to in house manufacture? Or to switch from a distributor sales model to a direct sales model? These changes will require a level of investment which can be built into the model. This can minimize the risk at the outset and maximize the value if the project is a success.
Although this makes a model more complex it provides a better base for decision making when comparing competing investments.
What You Need to Do - The How
For most projects one or more of four valuation methodologies can be used:
Payback Analysis – the amount of time required to recoup your investment.
Accounting Rate of Return – Net income divided by investment. Simply but ignores time value of money and cash flow
Net Present Value – calculates the net gain (or loss) from cash outflows and inflows over time. Useful when a second round of investment is or maybe required.
Internal Rate of Return. Delivers the rate of return over the life of a project. Often used in with NPV as NPV delivers a monetary value and IRR a %.
A key aspect is to ensure your are consistent in your assumptions where appropriate when comparing investments.
The longer the forecast period the less accurate the forecast. Five years should be considered a maximum. If you wish to forecast beyond five years use the perpetuity method.
Valuing your business. You may need to value your business when looking to sell, considering merging or acquiring another business, for financing purposes, when adding shareholders. Or you may just be curious.
Seven methods you may consider:
• Market Valuation
• Asset Based Valuation
• ROI Based Valuation
• DCF Valuation
• Capitalization of Earnings
• Multiples (Sales or Earnings)
• Book Valuation
However the buyer will choose the valuation method appropriate to them. In the end a business is worth what the buyer is willing to pay.
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