A repeated question that I have answered many times throughout my career has been, “how much is my company worth?”  Earlier in my career, I would have thought this question to be a simple and straight forward one, with a few possible answers.  However, as I have seasoned (code word for getting older) and experienced many different valuation situations from different professional perspectives, my answer becomes complex in many respects, yet more transparent and modest in others.

Over the past twenty years, I have had the opportunity to work as a private equity investor and lender to private and public companies, M&A investment banker, corporate development and strategy executive, finance and economics professor, and currently as a testifying economic expert, supporting attorneys, accountants, bankers and executives with their valuation and strategy questions.  These experiences have provided me with very unique transaction insights, seeing transactions as an investor, lender, agent, purchaser, seller and statutory and litigation support consultant.   Similarly, I have worked in situations that turned out to be monumental failures for investors, lenders and corporations to those which have turned out to be industry changing wins.  With these experiences, I have learned something very important – value is in the eye of the beholder. 

To some, an asset might be worthless, but to others this same asset may be the needed piece of the product line to connect disparate components of a product platform or to fend off a major competitor taking market share in a different country.  For an endless array of reasons, value is subject to the strategic needs of the person wanting the asset.  We typically refer to this value as a ‘strategic value’, signifying that the value of an asset can be greater or lower based upon the strategy and the needs of the parties.  Though this idea makes philosophical sense to an astute investor, there are many times where strategic value is not easily identifiable, and very hard to quantify when valuing a corporate asset. In these situations, valuation tools discovered in the academic community have been known to help identify an average, high or low value for an asset.  In no way are these valuation estimates an exact science but rather a normative artistic argument articulating various assumptions which in many situations are rational, though many times totally irrational, and it is up to the investor or its agent to decipher between them.

There are three methods with a variant of techniques which can be used to assist in establishing the value of a company. They are: the Income Method, Asset Method and Market Approach Method. In addition, there are two types of value that are used.  We broadly define these as fair value and fair market value, the former value is used in litigious and statutory accounting situations and the latter is relied upon when investing, buying or selling transactions.  This article, will address the fair market value approach to valuing a business entity using the Income Method.

The Income Method Approach is used to value an operating company by analyzing the future benefits associated with the investment or purchase, discounted by the risk of not receiving such benefits.  In my experience, this approach has been the most the most relied upon method used by many executives and business owners (but not the Courts – that is a subject for another day), as it provides a mechanism that enables a company to get the highest value from the lines of the business that the company excels in.  If a company (herein referred to as the Bee Hive Co.) has the ability to present and convince a buyer that their products are superior and is in greater demand than their competitors’ products, it is not very much of a challenge to convince the buyer that future sales are going to grow faster than their competitors. If this holds true, given a similar cost structure, there is a high probability that profitability will be higher as well.  We refer to this profitability as letter B, in our valuation model below.

Further assume that there is a structural change occurring in the market, where there is a chance that the Bee Hive Co. will not realize their projected earnings.  Perhaps the structural change is a slow but continuous move to the outsourcing of the services provided by Bee Hive Co., to a low cost producer in another country.  If this were the case, and if this had a chance of impacting the profitability of the Bee Hive Co., we would account for an increasing level of risk, noted as “r” in the following model.

Value of Company = B (next year) / (1 + r)(next year) + B (two  years from valuation date) / (1 + r)(two years from valuation data)….+B (future years from valuation date) / (1 + r)(future years from valuation data)….

Important the above equation is simplified for the user here, but in industry is presented much differently.

So, B is considered in most Income Method valuations to be a level of profit in the future, discounted by the chance of not receiving this benefit, recognized as “r”.  You can also look at “r” as the lost opportunity of not investing in some other company. Lastly, you can look at “r” as the periodic return that you need from your investment in the Bee Hive Co.  If an investor were to assume that everything in the company was to remain constant, yet risk was to increase, the investor can infer that the value of the investment would be less. Alternatively, if an investor were to assume that everything in the company was to remain constant and sales, revenue and profit were to increase, the investor can also infer that the value of the investment would increase as well.

There are many methods used to simplify this valuation equation, yet, understanding the rudimentary components of the equation is vital in helping a business owner determine what drives value for many buyers in the market.

Upon understanding the Income Approach method, many CEOs have spent considerable time driving growth in sales and doing an incredible job of increasing the profit margins, only to find that they were not getting the value they anticipated.  Overwhelmingly it seems that the good CEO’s are great at increasing revenue by driving sales. Many of them are remarkable at telling the story and selling the vision to investors.  I have historically referred to these folks as the King or Queen B’s.

When approached by several King or Queen Bees in the past, I was always comfortable knowing that they were going to hit their quarterly sales projections and forecasts.  However, what also became apparent with many of these companies was that the company’s risk was, on average, higher than the companies managed by other bees in the hive.  The reason for this is that many of the Queen Bees spent much of their time addressing sales and pushing for revenue growth and they failed to spend the needed time on operations, human resource development, information technology security(1), financial controls and similar functions.

Furthermore, a superior company with a value that far exceeds that of their peers needs to do more than meet their revenue and profitability projections.  They also need operations that are just as efficient as the sales team, and a culture that motivates people to want to stay and thrive in such an environment.  To be superior – you have to be superior in all aspects of your company.

What I like about the Income Approach Method is the idea that we can quickly identify and compare areas of benefit and areas of risk against peers, with the hope of identifying areas of value, and areas of weakness.  By utilizing the Income Approach Method, a business owner gets closer to identifying strategic areas of risk and reward, and establishes a benchmark from which to begin a process toward driving extreme value(2).

Young, Christopher. 2011. “Addressing Cyber Value.” http://reinventingthetape.wordpress.com/2011/05/18/addressing-cyber-value/

Young, Christopher. 2013. “The Singularity of Purpose Drives Extreme Value.” http://reinventingthetape.wordpress.com/2013/11/27/the-singularity-of-purpose-drives-extreme-value/