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How to answer the question: “What is Valuation?”

Sageworks
November 10, 2015
Read Time: 0 min

Business owners might ask the question “What is a valuation”?  Or, “Why does my business need a valuation?”.

Professor Aswath Damodaran, a Professor of Finance at NYU Stern and frequent writer and speaker on valuation, writes:

“Knowing what an asset is worth and what determines that value is a prerequisite for intelligent decision making — in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making investment, financing and dividend choices when running a business.”

The key phrase is “intelligent decision making”. Business owners are faced with decisions daily, but rarely is there a way to prioritize how to make those decisions. For example, when an owner has a profitable year, where should she or he reinvest?

By analyzing a company’s financials through the income, market and asset approaches, valuation professionals hold one of the true keys to long term business success: insight into how and where the owner couple make changes that impact the long term value of the company. When a company is founded, there may only be an idea of a customer need and an idea of a product or service that could fulfill that need. At a recent valuation conference, the owner of a successful practice shared the story of how he started his firm. He had no clients and somehow convinced two colleagues to start the firm with him. Through the advice and goodwill of others, he built a book of business. Most of his clients resulted from spending time at a local coffee shop where business owners gathered for meetings. One by one, clients came to his practice for help with their businesses.

Now near retirement, he said that everyone needs advice from time to time. Sometimes it takes a 3rd party looking in to see where the opportunity – or the risk – lies.

One of the biggest decisions a business owner will make is when to sell and for how much. Exit planning is of primary importance to valuation firms because it is an enormous source of business. It is the obvious time that most business owners know that they need help. However, like a savvy investor, business owners should know that asset values can change from year to year, and if they change enough, it might be worth selling the business long before retirement. Additionally, unlike the average shareholder of a publicly traded company, a business owner can take actions that will increase or decrease company value over time.

Homeowners living in a dynamic market might consider a home appraisal every few years to see if perhaps they could sell their home for a significant profit. Business owners with a growing company or one in a dynamic industry might consider the same approach.

With 75 percent of businesses never selling and 90 percent of business owners’ net worth tied up in the business, it is no surprise that exit planning is a common reason valuation professionals are hired. It could also be true that if business owners planned earlier, they would be more likely to sell their businesses.

Yet performing a valuation is not as simple as ordering a steak for dinner and deciding whether it should be rare, medium or well-done. Savvy valuation professionals recognize that a “back of the napkin” approach to valuation won’t secure the best result. It’s important to follow the three major approaches: income, market and asset. It’s also important for the valuation professional – and possibly the business owner – to recognize some of the pitfalls related to valuation. The process isn’t always simple and even a small choice can dramatically impact the final value.

Accuracy and risk reduction become important factors in delivering high quality service to business owners. Damodaran also points out that bias, uncertainty and complexity play a role.

In your next prospective client meeting, or while speaking with an existing client, ask about their next big decision. Maybe they are investing in a new manufacturing facility, considering the purchase of a new tractor trailer or buying a dishwasher for their restaurant. In each case, these costs can impact the short and long term value of the business. Knowing which choice to make is often the most difficult choice of all!

Additional Resources
Infographic: 6 Things to Know About Buy-Sell Agreements
Whitepaper: Generating an Accurate Business Valuation
Introduction to Valuation by Aswath Damodaran

Sageworks Valuation Solution
Sageworks Valuation Solution is a web-based, business valuation solution that helps firms streamline workflow, scale existing processes and increase realization rates. Explore features and benefits by watching a one-minute walkthrough video.

About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest

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