For closely held businesses, the methods used for valuation can vary greatly depending on the type of business and the event that’s triggering the valuation. Traditional valuation methodology might take a top-down approach. This means the appraiser looks at the macro trends of the business, like historical performance and financial numbers over time, to come up with an estimated value. Another method uses comparables, similar to what’s done for real estate valuation. Your home can be valued based on how it compares with other homes in your neighborhood. Similarly, a business can be valued using comparable businesses in the same industry. However, there are limitations to traditional top-down corporate valuation methods. They often fail to capture key customer-driven indicators of company value. They don’t focus on the customer-related activity that generates the company's revenue. And they sometimes tend to be backward-looking, drawing conclusions from past financial numbers. But the key is they might miss valuation enhancement opportunities we’ll cover in our next article.
Customer-Based Corporate Valuation
An increasingly popular approach to valuation is known as “customer-based corporate” valuation, or “bottom-up” valuation. This method starts by analyzing customer-level data and the impact on revenues. This might, for example, be used with companies that have negative cash flows.
It’s interesting to note that public market companies tend to take this approach far more often with privately held “mom and pop” businesses. Because public market businesses typically have a 20% to 30% premium over private companies, taking a cue from the way they value themselves might be a good idea.
Another valuation approach in the public market space is the subscription model. Businesses that sell products like software are increasingly converting to monthly, quarterly or annual subscriptions. Having this predictable income at regular intervals increases value and makes the business easier to sell. But apart from merely valuing the client’s business, reconsidering how the business might be viewed, and perhaps changing its revenue model, might provide revenue enhancement and/or consistency, either of which might enhance the company’s sale value and hence the client’s overall retirement plan.
Uniqueness of Business
It can be beneficial to evaluate a business’s value from several perspectives. Consider the example of a company that produces medical instruments. There are two value components to that type of business: 1) the hardware and 2) the service. Valuing the hardware side of the business might be done using traditional top-down valuation techniques. Whereas demonstrating the value of customer-driven factors on the service side might best be achieved using bottom-up methodologies.
When it comes to valuation enhancement (not merely the determination of a value for the business), what you really want done for your client is to provide an approach as to how to think about the value of that company. Some companies simply don’t fit into a standard mold. If you miss out on the nuances or the uniqueness of a company, you could miss out on capturing its true value.
Impact of Crisis
As we’ve seen with COVID-19, a business’s value can change for the worse (and in more limited situations perhaps for the better) seemingly overnight. The effect of the pandemic on businesses around the world has been devastating. For many companies, actual and expected revenues have decreased along with cash flow. Risk factors that impact discount rates have suddenly changed in unprecedented ways, making valuation a difficult proposition in the short term.
The longer-term impact may not be known for years. But it’s clear that some industries will suffer, some will remain relatively unaffected while others may even prosper beyond historic measures. Businesses like airlines and restaurants where people gather in dense areas will clearly see suffering and lingering effects for years. Essential businesses like grocery stores, banks and trucking companies will continue to be essential. Meanwhile, other industries suddenly find themselves benefiting from COVID-19. Streaming services like Netflix and online gaming platforms are thriving. Video communication companies like Zoom have seen their stock value rise.
In this new and uncertain climate, business owners will need to be nimble, flexible and willing to pivot if they want to recover, preserve or even enhance the value of their company before they sell it and retire.