Key Value Drivers of a Business Part 1

 What are the key value drivers of a business and how are they used to determine the company’s worth?
Business owners often ponder what their businesses are worth and whether they have done a good job in growing their value over time. While a key indicator of business success may be from growth on top-line revenues, this factor alone might not translate into growth in business value.

• In Part 1 of our three-part series, we explore the general concepts of business valuations, including methodologies employed by valuation professionals.

• In Part 2, we will examine the other key value drivers of a business in determining the health and well-being of the company, namely, areas business owners can focus on in increasing the value of their business over time.  

• Lastly, we will discuss how to increase value of a business and the winning strategies owners can take.

Calculating Business Valuation 

To begin a business valuation, the valuation expert would first assess whether the subject company can operate as a going concern or not.

GOING CONCERN - In general terms, a going concern means the subject company or business can continue to operate and meet its financial obligations for at least the next 12 months.
NOT A GOING CONCERN - If the subject company is not a going concern, the valuation expert would value the company under liquidation assumption whereby the company’s assets are valued based on their liquidation values.
If the subject company is a going concern, valuators rely on three generally accepted approaches in determining the fair market value:

1. The Asset Approach

2. The Income Approach

3. The Market Approach

A simplified roadmap of the various considerations that valuators make in determining which approach and method to use is as follows:       

The Asset Approach  

One of the key value drivers of a business is the Asset Approach, which focuses on the company’s tangible assets and liabilities. The Asset Approach is frequently used when the value of the business is tied in the underlying assets of the company rather than its earnings.

Typical examples of companies that would be valued under an Asset Approach would be real estate or investment holding companies. These types of businesses do not have any active business operations and the return on the company’s capital is generated mainly from the investment returns derived from the assets as opposed to any real operations.    

The Adjusted Net Asset Method – This is a commonly used method to estimate the value of a company using the Asset Approach. This method involves adjusting the book values of the company’s assets and liabilities (i.e. the balances reported on the balance sheet) to their respective fair market values. Offsetting the company’s assets with the company’s liabilities result in the value of a company’s shares.

While typically straightforward to perform, the Adjusted Net Asset Method excludes any valuable internally generated intangible assets such as customer relationships, brand value, industry reputation and commercial goodwill. Consequently, the Adjusted Net Asset Method is not applied to companies that have a profitable operating business with significant intangible value.

The Income Approach                 

The second key value driver of a business is the Income Approach where the present value of future earnings associated with ownership of the business is quantified using a rate of return that reflects the risks associated with realizing those earnings.
This Income Approach is used to determine the value of a business that is generating income for distribution to shareholders. Common methods under the Income Approach include:

• Capitalization of Maintainable Earnings Method

• Capitalization of Cash Flows Method

• Discounted Cash Flow Method

If the company’s historical earnings are a good representation of future operations, the Capitalization of Maintainable Earnings or Capitalization of Cash Flows Methods are applied; the difference between these two methods involve mainly whether amortization expense reflects the operation’s annual capital asset reinvestment.  

Preference is often given to the Discounted Cash Flow Method in situations where either the historical operating results are not a good indicator of future operations or if the business has yet to stabilize and reliable long-term forecasts are not available. 

The Market Approach

The third key value driver of a business is the Market Approach. As the name implies, the Market Approach assesses the value of a business based on observable indicators dictated by the market. Common methods in this approach include:

• Precedent Transactions Method

• Comparable Company Method

The Precedent Transactions Method – Also known as the Comparable Transaction Method, this involves reviewing actual transactions in the open market whereby the companies involved in such transactions are considered comparable to the subject companies (e.g. in size, industry, geography, market penetration, risk and growth and potential).
The Comparable Company Method – This method considers the trading multiples observed in comparable public company stocks. Adjustments are usually made to these trading multiples in order to make such multiples applicable to the subject company in question. 

Next Steps in A Business Valuation

Once the valuator is satisfied in choosing the most appropriate valuation approach and methodology for the subject company, the valuator will then perform the calculations necessary in the methodology while making adjustments specific to the company to appropriately reflect the specific risks in the business or the assets.

Now that we have a general understanding of the three key drivers of a business and the different approaches and methodologies involved in a business valuation, in our next blog we will explore in more detail these key areas that drive business value in a company.

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Manning Elliott is here to help. To assist business owners and professional advisors, visit our blog to stay up to date on the most recent valuation topics.

If you have any questions on how to value your business at this time, please contact William Tam, CPA, CA, CBV directly.

This content is believed to be accurate as of the date of posting. Canadian Tax laws are complex and are subject to frequent change. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.