Today we continue exploring three business valuation methods that I have suggested to Hilal, a property investor who lost a significant part of his income due to Covid-19.
Many of his tenants have either left or ceased operations, leaving him with only 20 per cent occupancy. Each methodology is compared to a real estate valuation to make it relatable for Hilal.
For those who missed last week’s column, we have started with the bottom-up valuation, where all costs are kept in account and the entrepreneur should calculate how much would cost to get to the same current status by starting all over from scratch.
Today we are completing the “tour” by discussing two more valuation methodologies.
2. Comparing uniform data
Another strategy could be to “shop around” the neighbourhood. I am sure that Hilal has done this before buying one of his many properties. He might have checked out other shop lots in the same block, other villas in the same stretch etc. This is certainly comparable to what can be done in business.
Hilal could identify similar businesses and through some little investigation find out the value of comparable competitors. This strategy works quite well for commoditised businesses, such as a barber shop for example.
Commoditised businesses are those that offer interchangeable services. If one is closed today, a habitual client can get the same product or service elsewhere without searching too much.
In other words, the discrepancies between them are limited. The most successful and the least successful are not too far apart. This condition does not apply, however, to the third type of valuation.
3. Discounted cash flow (DCF)
DCF is a valuation method that brings back future earnings to present days. If we apply this logic to real estate, it is as if we were to calculate potential earnings from rent over a certain number of years and consider that amount as a starting point for our negotiation.
In this case however, some qualifier might apply.
For example, if Hilal intends to invest in a tech business, it is important to keep into account the specialisations and the existing contracts. Obviously in this field the second method of valuation proposed in this column would not apply.
For example, a tech business with multiple certifications and existing government contracts, could generate significantly more profit than another comparable business without such credentials.
Therefore, this third methodology applies quite well to in homogeneous activities that largely differ in terms of performance.
As you can imagine there is no right or wrong, although each approach might be more suitable for certain types of businesses.
An idea could be to have a framework in mind that encompasses all three methodologies in percentage. For example, we could consider the following mix before investing in an engineering company:
Priority to be given to Discounted Cash Flow (DCF) keeping in account current contracts. This could account for 50 per cent of our valuation, accounting for the actual revenues and profit of the business we are negotiating for. We could then add a 30 per cent valuation based on comparable data from other engineering firms in the same segment and geography.
Lastly, we could assign a 20 per cent to rebuilding the business bottom-up. This would provide Hilal with a very accurate valuation before he enters the last stage of negotiation.
(The columnist is a member of the International Press Association)
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