If you’re thinking about buying a business, have you ever wondered, “What am I really buying?” It’s easy to think you’re just buying a brand, some assets, and maybe a loyal customer base. But here’s the truth: What you’re really buying involves more consideration than that. Let’s break it down.
Beyond the Obvious: The secret sauce of a business’s value
The obvious answers may include the brand, assets, inventory, customers, and labour and all these assets may have some value on their own. However, the actual value of the company can only be appreciated when they all function together.
All these factors, when combined, make up the business’s operating activities, which result in profits or cash flows. The extent to which the company can maximise the return on its tangible and intangible assets determines the level of earnings and cash flows it will generate.
The value of a business is thus determined by the future level of cash flows that it may generate, discounted by the required rate of return. So, when you acquire a business, you are essentially purchasing the future cash flows that the company will be able to generate for you as a shareholder.
Forecasting the Future: Where the real work begins
Because the value of a business is determined by its future cash flows, attention needs to be on the financial forecasts. Here’s what you need to focus on:
- Look back to move forward: Historical Analysis
A detailed historical analysis of the target company’s financial performance is required to understand items such as past profitability margins, working capital requirements, revenue and expense growth, capital expenditure, anomalies, one-time revenue/expenses, and so on.
The information acquired during this phase will be used as part of examining the reasonableness of the financial estimates.
- The crystal ball: Predicting Growth in Income and Expenditure
While there should not be a “one-size-fits-all” strategy for projecting income and expenses, the following factors can be considered:
- Historical growth rates.
- Present and future market conditions.
- Present and projected inflation rates.
- Identify the target company’s strategic objectives and key performance indicators.
- Forecast GDP rates.
- Accessible industry data.
- Target company’s performance compared to the industry’s performance
- Cash is king: Working Capital Requirements
Managing working capital requirements is critical to the success of any company’s operations because cash flow is the lifeblood of any business. Working capital requirements must be considered when appraising a business.
When determining the target company’s expected working capital needs, it is critical to evaluate previous working capital rates, understand any significant fluctuations in this data, and assess any sound measures to optimise working capital.
- Maintaining operational efficiencies and supporting growth: Capital Expenditure
Another essential factor to examine is how much the company will need to spend to repair or replace its assets to maintain its current level of operations and profitability.
A review of past capex spend can provide a high-level indication of what this level should be; however, other factors such as ageing PPE, changes in business operations, changes in customer needs, changes to product lines, technology, supplier changes, macroeconomic conditions where capex is imported, and so on are among the other factors that should be considered.
Where the forecasts reflect growth above the existing level of operations, the capex requirements to enable these growth forecasts must also be carefully considered.
What is the bottom line when valuing a business?
When valuing a business, numerous factors must be taken into account, but ultimately, one of the key factors that influence the value of a business is the future cash flows it can generate for its shareholders.
Ready to dive deeper? Learn more about our Valuation Services and process, and contact us for a consultation.