WHAT IS YOUR COMPANY WORTH?
Written By
Carlos Ramos
EVP, Middle Market Banking Group Leader
You had a big idea a few years back and turned it into a great business. So, what is the value of your company today? And will your future moves enhance or erode that value? Here’s a straightforward way to know what your company is worth.
When business owners ask us for a business valuation, it’s much bigger than determining company net worth.
At Banc of California, we understand the application of modern portfolio theory to medium-sized enterprises, and we have some insights on measuring and building the value of smaller companies. While no one can tell you what your company is worth without a significant time investment, we can share a few tenets of finance that may provide a useful framework for thinking about your company, expected performance and the implications for value.
Expected free cash flow can define almost any company’s value
Free cash flow is everything left over (in cash) after bills are paid and reinvestments have been made to keep the company up and running. When you see acquisition prices quoted as multiples of revenue, profit and EBITDA, these are only proxies for the expected cash-flow-producing capabilities of the firm.
When it comes to how to determine business value, all that matters is how much cash a company can generate, less the investment necessary to get it. Now, there are adjustments for the time required to generate that cash flow, not to mention the risk that the expected cash flow might not develop. But understanding how a company’s value ties back to free cash flow is the “Rosetta Stone” of corporate valuation.
How do you figure out free cash flow valuation for your business? Spend some time with your banker and build a forecast of your balance sheet, income statement and cash flow statement. Five to six years is usually long enough for a stabilized performance to emerge, including a cycle of reinvestment. Annual capital expenditures are volatile for most medium-sized companies, and reinvestment requirements are more clearly identified in longer-term forecasts.
The forecast should be neither conservative nor aggressive — just a reasonable estimate of the company’s potential. Discretionary expenses, such as unusual travel or entertainment or payroll to your unproductive brother-in-law, should be excluded. You want to showcase the cash flows available to any new investor. Distributions to shareholders or owners and payments on principal and interest to debt holders should be added back. The value of the enterprise is independent of how the cash is distributed.
Once you and your banker have built the forecast, pull the free cash flow out of it. That’s the excess cash that piles up on the balance sheet without consideration of distributions.
Adjust Your Cash Flows for Risk and Time
Timing is a fairly straightforward concept — but it’s critical for any business valuation technique. Cash flows 10 years from now are worth a fraction of cash coming in tomorrow. The risk adjustment is substantially trickier, and a discussion of all the issues, theories or nuances of risk is beyond the scope of this article. Simply stated, the risk adjustment factor, or discount rate, is the opportunity cost of having your capital invested in a similar project.
Calculating Expected Return in Free Cash Flow Valuation
The expected return or “cost of capital” is made up of two components: the cost of debt and the cost of equity, multiplied by their respective shares in the capital structure. We recommend using target capital (the ideal mix of debt and equity) as opposed to what you are currently carrying. In our example below, we assume a 50% debt-to-capital mix, which is not far from where most businesses operate. Capital is simply debt plus equity.
For this business valuation method, the cost of debt is not the rate your current lenders charge. Most banks and finance companies lend in the short term and base the rate on short-term indexes such as the Prime rate. Today’s Prime is not a good representation of where Prime may be five years from now, so it’s best to use a long-term rate in your forecast — for example, the 20-year Treasury plus a credit spread. If you are a near-Prime borrower today, we suggest using a rate of 6%, which is a more reasonable estimate of what you will likely pay over the long term.
The cost of equity is a different story. Nobel Prizes have been awarded to researchers for trying to determine what rate of return equity investors are demanding. Even more confusing, there is little agreement on what the cost of equity is (or should be) for a nondiversified investor or entrepreneur. The research on equity premiums has largely been focused on public companies, where information and trading histories are readily available.
The only consensus for private companies is that they should earn an additional return premium over exchange-traded stocks to compensate for the additional risk of size, lack of liquidity and the inability to diversify company-specific risk. Just how much of a premium is still subject to debate, but a proxy is better than nothing. For purposes of our example, we assume a cost of equity of 16%. In our example, the weighted average cost of capital is 50% of the cost of debt, adjusted downward for its tax deductibility, plus 50% of the cost of equity. That is: [0.5*6.0% *(1-.30)] + [0.5*16%]=10.1%. So the weighted average cost of capital in our example is about 10%. This number may seem low because higher returns are often reported in the press. But those are returns on equity, not total capital. We are measuring cash returns (not earnings) on total capital (not just equity). A company’s capacity to produce free cash flow relative to the total capital required to produce it is the heart of company valuation.
Run “What If” Scenarios to Assess Potential Business Value
Run a series of scenarios against the model to determine whether your strategies increase or decrease what your company is worth:
- Will the cost of your new expansion plan increase company valuation or just the size of your firm? (The two are not always related.)
- Is taking on a new, large customer at lower margins and an increased working capital burden worth it?
- What steps can you take to maximize value?
- What is a single margin point worth in total company value?
- Most importantly, if you execute your most optimistic plans, what will your company be worth?
Magnitudes of change can be calculated as well. Take the difference between your return on capital and your cost of capital and multiply it times the capital deployed. Multiply that number times the number of years you expect to sustain the returns and, voilà, that’s the value being created above the capital invested.
So, here is our formula: Value Created = (Return on Capital – Cost of Capital) × Capital Deployed × Years
Now, let’s consider an example to make this more concrete:
We’ll assume the following values:
- Return on Capital (RoC): 15%
- Cost of Capital (CoC): 10%
- Capital Deployed (CD): $1,000,000
- Number of Years (N): 5 years
Plugging that into our formula: Value Created = (0.15 – 0.10) x 1,000,000 x 5, or $250,000 in this case.
Cash Returns Above Cost of Capital = Value Creation
Being able to represent all the variables in your business in a single model that can “price” decisions offers a big assist in decision-making. Of course, determining business value is much more complicated than this simple model, but the free cash flow method of business valuation provides a compass to guide you in the right general direction.
In finance, the definition of risk is uncertainty. Surprises are every business’s worst enemy, so the banker’s role is to help business owners anticipate those surprises and plan accordingly. Contingency planning is about navigating challenges as well as capitalizing on opportunities. It requires looking into the future, far beyond your company’s day-to-day activities.
At Banc of California, we are committed to partnering with you for the life of your business. Our experienced banking team will provide the insights you need to grow your business and help you measure and maximize the potential value of your company.
For more information on how we can help you navigate the challenges of growth and the unexpected, visit us today
CONNECT WITH A RELATIONSHIP MANAGER
COMPLETE THIS FORM OR CALL
877-770-BANC (2262)