Valuation for Entrepreneurs

If you own something valuable, you'll probably be interested in knowing its value at one time or another. Oddly enough, though, many entrepreneurs don't understand how to accurately value what is likely their most important "possession": a business. We're here to help.

Let's first eliminate a few misconceptions about exactly how to value a company:

1. The value isn't equivalent to the firm's assets. Assets held on the balance sheet will help you determine the book value of the business but that is merely an accounting matter.

2. The value isn't equivalent to the firm's assets less any liabilities. Again, that would be part of the book value equation (assets minus intangibles minus liabilities). Businesses rarely sell for book value. Don't sell yours so cheaply either.

3. The value isn't equivalent to a sum of the firm's future accounting profits. Earnings reported on the income statement are a poor performance measure for all but the simplest firms.

How, then, do you value a business? You use the formula below...

where n is the number of periods until infinity,
CF is a specific cash flow,
t is an explicit period of time,
and r is the discount rate (typically the cost of capital)

Our math essentially states that you should value a business as the present value of the sum of all of its future cash flows. You’ll be happy to know this same formula applies to any asset, whether a stock, a parcel of land or a piece of art. Valuation is a universal concept with a rather intuitive foundation: You would rather have cash today than tomorrow, and you don't care about anything except for actual cash. Accounting profits regularly differ from cash flow, so we can't use earnings in the valuation itself. (Depreciation of an asset, for example, reduces profit but not cash flow.)

If you feel comfortable forecasting your firm's future cash flows, then the only remaining challenge is to determine your company's discount rate. (See the formula above to understand why you need this rate.) Calculating the discount rate for a small business is actually more challenging than it is for a publicly-traded firm like Apple. Why? Almost no entrepreneur can tell you his/her cost of capital.

Let's frame the question differently: How much are you paying for money to fund your business? For simplicity's sake, assume that you fund 30% of the business with debt and the remaining capital comes from your own savings. The cost of the debt equals its interest rate, 8% for our example. What about the cost of your own investment? Just insert the rate of return you need to earn each year to be willing to keep the business open. Here, we'll assume 10% is your requirement. To determine the discount rate, then, use the following formula:

where r is the discount rate,
wd is the weight of debt in the capital structure,
id is the interest rate of debt,
we is the weight of equity in the capital structure,
and ie is the required rate of return on equity

﻿While the examples above are simplified and real businesses frequently require significantly more detailed valuations, we've outlined the essential quantitative and conceptual framework. We don’t recommend developing any valuation unless you're comfortable with Excel, though. You don't want to attempt the math on a calculator. Trust us. If the numbers make your head hurt, get in touch with us for guidance!

Examples are hypothetical and for illustrative purposes only. The rates of return do not represent any actual investment and cannot be guaranteed.