When it comes to investing hard-earned cash, it’s obvious to consider the options. But some business owners may forget to answer a few fundamental questions that may translate to inefficiencies when it comes down to making business investment decisions.
Over the next few days, CanadianManufacturing.com looks at how to measure value, and how to create it.
There are two ways to determine the value of a company: going-concern or liquidation. With a company expected to continue operating, a prospective buyer evaluates the risks and expected returns of the investment on an ongoing basis.
A number of valuation methods can be used but those applied to the valuation, but all can be broadly classified as market, income or asset approaches.
Valuation is primarily driven by three elements: quantum, quality and capitalization.
Quantum of cash flows reflects revenues generated by the business minus the costs associated with generating those revenues.
When valuing a business, potential buyers study these factors over a three or five-year historical period, as they are often used as a starting point to estimate maintainable future results. A business valuator or prospective buyer will look for cash flow patterns and volatility.
But the quantum of cash flows shouldn’t be considered in isolation.
Quality refers to cash flow sustainability, variability and sensitivity to risks.
Risks associated with the cash flows are reflected in the value of a business by the multiple or capitalization rate applied to those cash flows. Many operating businesses are valued on a multiple of earnings or the present value of expected future cash flows.
Check Monday’s CanadianManufacturing.com Daily for the second installment, Creating value and how to realize it: value creation.
Suzanne Loomer is Managing Director at Campbell Valuation Partners Ltd. in Toronto. She can be reached at email@example.com.