You Want To Know How To Evaluate A Company?
The process of accurately evaluating a business is very involved and time consuming; and most often the process is referred to as a “business valuation” or “valuing a business”. Nonetheless, if you have asked the question “how to evaluate a company?” the end result you are looking for is a hard number that is the business’ value.
This is a big question and deserves active consideration and analysis. You see, many factors come in to play when determining business value, and it shouldn’t be rushed, lest important value drivers be overlooked.
Some important factors include:
- how profitable is the company?
- what are the growth opportunities?
- in what areas is the company vulnerable?
- how risky is the industry?
- how large is the company?
- how do the company’s performance metrics compare to your industry?
It is value driving factors such as these that are taken into consideration when determining what a company is worth.
How profitable is your company? – Let’s consider two companies. Company A has annual revenue of $1M. Company B also has annual sales of $1M. So are they worth the same? Probably not. Any rational investor would willingly pay more money for the company that will generate a higher level of earnings. So while revenue is a factor, the amount of profit generated usually will be more relevant to business value. How profitable is your company?
What are the growth opportunities? – A critical component of business valuation revolves around growth opportunities: how much money will the company make for me in the future? Let’s take two companies: Company A, with sales of $1M, is an established plumbing distributor, and Company B, also with sales of $1M, is a biotech startup. The biotech startup will have much more upward pressure on its selling multiple because the biotech industry has much greater growth potential than the plumbing industry. What are the growth opportunities for your company?
How large is your company? – All other things equal, a company with higher revenues will trade for a higher multiple. For example, let’s consider two companies. Company 1 has $1M in sales and a 10% margin: it makes a profit of $100K per year. A larger business, Company 2, does $10M in sales and makes $1M in profit; the profit margin is the same as the smaller company, 10%. However, Company 2 will trade at a higher multiple. This is known as the “size effect”, which simply reflects the fact that larger companies trade for higher multiples. How does the size effect apply to your company?
Performance metrics – How well do you perform relative to your industry peers? As mentioned, a company’s ability to generate earnings is fundamental to business valuation. But company values can move up and down within a range of possible values. Where should your company fall within that range? Performance metrics are an important tool to help answer this question. For example, let’s say your company does $1M in sales and produces a 10% profit. And let’s say another company does the same: $1M in sales and a 10% profit. Are they worth the same? Let’s add that your company’s management ratios (asset turnover ratios) are all much stronger than the other company. And let’s add that your short and long term solvency ratios are much better, i.e. you have a much stronger balance sheet. And your ROE (Return on Equity) is more than double the other company. Does this mean you are worth more? All other things equal, you bet it does! What are your performance metrics and how do you compare to all of your industry peers?
How does all of this come back to your original question, “how to evaluate a company?” Well, to accurately determine business value requires a lot of analysis, research and judgement. Many factors are involved and there is no simple, formulaic answer. There are professionals (like your author) that devote their careers to this exact endeavor.
Consider this, for example. Let’s say you own a dry cleaning company. This is a mature industry that is not expected to grow quickly: growth opportunities are limited. In a sampling of over 150 real-life, actual transactions of dry cleaners the multiples showed a very wide range.
Company Value-to-Discretionary Earnings: the dry cleaner transactions show that top dry cleaning companies traded at a multiple of 10 times discretionary earnings. Companies on the low end traded for less than 1 times discretionary earnings. This is a very wide range of values!! From less than 1 all the way up to 10. To be clear, this is saying that if your discretionary earnings were $100K, the possible range in value could be from $80K all the way up to $1M. This is a terrifically wide range in values, and for dry cleaning companies!! This industry is not known for dramatic innovation and higher-than-average growth. So where would your (imaginary) dry cleaning company fall in that range? The actual value will depend on all of those factors discussed above; growth opportunities; profitability; size, etc. Getting an accurate value requires an experienced eye with specific knowledge and judgement in the realms of business, finance, and markets.
So why do you want to evaluate a business? Are you just curious? Are you considering an exit? Is it for gift and estate planning purposes? Or is it for general business planning? If you have questions about the value of a business, feel free to give us a call. We’d be happy to know more about you and understand your situation.