At the core of every business valuation, whether of an entire business or an interest in a business, lie three key elements that must be examined and understood. This is true regardless of the seeming complexity or simplicity of any valuation situation. The elements are expectations for cash flow, the expected growth in cash flow, and the risks associated with achieving the cash flow. In this short video post, we “Keep It Simple, Sally or Stewart” and will elaborate on the concepts in the near future.
Hello, Chris Mercer at ChrisMercer.net. Recently, I did a post – the idea of which was to keep it simple. It focused on a single graph, which I think won the day in a trial regarding the valuation of a business. “Keep It Simple Sally” or “Keep It Simple Stewart” is the focus of this particular post – it’s a short one.
Value is all about three things – business value is all about three things –and three things only. We have to focus on those three things. They are the cash flow that’s expected from the business, or the interest in a business, the growth of that cash flow, that is the expected growth into the future, and then the risks associated with achieving those cash flows. Valuation they say is the present value of all expected future benefits from a business discounted to the present at an appropriate discount rate. We’re talking about three things: cash flow, risk, and growth. Those three things can be put into a simple little formula, Professor Gordon, thank you very much. Value is equal to cash flow capitalized by, or divided by, “R” risk minus growth, “G.” That’s three things: cash flow, risk, and growth – that can be further simplified into value is equal to cash flow times a multiple.
Business owners and attorneys and appraisers are familiar with this formula because we hear it all the time in terms of rules of thumb –“My business is worth 6x EBITDA.” The cash flow is EBITDA; the multiple is six. Where did those come from? We can talk about those another time but business valuation, whether we’re talking about a strategic value of a business, that is the highest possible value, or an illiquid minority interest in the business, is all about the cash flow attributable to that business or that interest, the growth of that cash flow attributable to that business or that interest,and the risks associated with achieving those cash flows either for the business or the interest. So “Keep It Simple Sally,” “Keep It Simple Stewart.” Focus, when we talk about value, on cash flow, risk, and growth and the expectations for those three things. We’ll elaborate on these principles more in future posts. Good day.