Understanding Business Valuation Basics

By Mónica Hernández 

In today’s dynamic corporate world, there are many circumstances when estimating the value of a business or its related assets is required. Therefore, as a beginning step, it is quite useful for any business owner or high-level manager to understand the logic of how the fair market value of a business is estimated, and what are the key variables impacting it.

Value from a business is generally derived from the future disposable earnings/cash flows that the business generates, once all operating expenses and commitments to third parties have been covered.  In other words, value is proportional to the prospective free cash flows the business is expected to produce, which means the higher the expected available cash flow, the higher the value.

Please note that we are referring to future cash flows; although the historic performance of the business is undoubtedly one of the factors to consider when estimating future behavior, there are other important aspects to consider as historical results are not enough indication of the future.

Overall, there are two basic approaches to estimate the value of a business. If the company is operating and is expected to continue doing so, then the most appropriate method to use will be the “Income approach”, which is based on the future earnings of the business. On the contrary, if the company will not continue to operate, or profitability is not foreseen in the future, then the “Asset approach” will be a suitable method to estimate the market value of the assets the company owns.

In this article, we will go over the basics of the Income approach, as our objective is to explain what the key variables are impacting business value for operations expected to continue.

There are two basic process steps to estimate the value of a business using the “Income approach”:

1) Forecasting the future earnings, 2) determining the appropriate rate to reflect the risks associated with the earnings of the business.

  • Forecasting the future earnings/cash flows: Basically, we need to project the most likely cash flows that will be available from the business after having covered all expenses and commitments (including debt and taxes) with third parties. Thus, we forecast revenues, operating expenses, financial inflows/outflows, and investments needed to support the operation.

    When projecting all those future streams, not only the history of the business is considered, but also, other qualitative and quantitative factors from the overall economy expected performance, the industry-specific dynamics, the company business plan and its competitive position in the market, among others.
  • Determining the appropriate rate to reflect the risks associated with the earnings of the business: The value of the same nominal amount of money changes over time. Having a hundred dollars today is not the same than to have the same amount in 2 years from now. The intuitive notion of how money value changes, may be understood from the purchasing power fluctuations over time (inflation), which is a concept that most people are familiar with.In business valuation, there are other factors (not only inflation) that affect how the nominal value of the money changes over time, such as the macro-economical risks of the country, the cost of accessing credit, the risks inherent to the specific industry, the strengths, and weaknesses of the company being valued, and a few others.  All those risks are considered when bringing the expected future earnings into present value.  The pace at which such future benefits are brought into the present value is called the discount rate, as future earnings value is “discounted” into the present.

To illustrate, let´s contrast the value of two very similar businesses competing in the same market, company A and company B.  Both produce earnings of $1.0 million per year and are expected to grow at 5% on an annual basis. Company A has established multi-year contracts with all key its clients, has a well-diversified customer-based, and has established some penalty fees if they default to meet expected purchases in the next five years.

In contrast, Company B has not signed any contract with customers, but rather sells on a spot basis.  Naturally, even if the earnings of both companies are equivalent, the risks associated with  company B (uncertainty of revenues) are higher, so the discount rate used when estimating value should be higher for Company B.  Just for the sake of this example, let´s assume that the appropriate discount rate for Company A should be 10%, while for Company B 18%.  Refer to the example below to compare the value for both companies.

In conclusion, all actions that increase disposable earnings and all tactics implemented to mitigate the risks associated with achieving those profits will positively impact the value of the company. 

Mónica Hernández is a business valuator at FY Canada and assists clients in improving their performances through negotiation and strategic planning. Due to her training and experience, Mónica also works with Mergers & Acquisitions and Corporate Finance.

Performance Management & KPI

 

Performance Management & KPI

 

By Talita Queiroz

In an increasingly competitive market, companies should recognize the importance of measuring their performance, not only to keep them running but also to grow effectively and profitable.

Luckily, companies can count with a multitude of management tools to assist them in this task, where the best approach/tool will depend on how much effort the company is willing to spend in planning, analyzing, and reviewing results. In this piece, we will go over the basics of Key Performance Indications (KPIs), one of the most popular concepts in the corporate environment.

KPIs are nothing more than the establishment of the most relevant indicators to analyze the performance of a company, a project, or even a person, translating strategic goals into measurable results. Also, it enables the company to track results, analyze the historical performance, and link results with facts. There are two levels in which KPIs are applied, organizational level and or individual level.

In the organizational level, companies can apply KPIs to measure, for instance, margin per sales, margin per product, revenue per employee. It could also be used to calculate the viability of specific projects, such as cost per project, return on investment (ROI) and capital gains. At this level, individual contribution is considered to calculate results, but it is not the purpose of the analysis.

At the individual level, KPIs measure people’s performance and their alignment with the organizational objectives, such as sales per salesperson, productivity, number of working hours per employee. The trick here is to ensure that these indicators support the organizational goals.

Let’s assume a company wants to increase its brand awareness. A good organizational KPI could be the number of sales to new clients, and the individual one could be the number of new clients per salesperson, as detailed in Figure 1. Therefore, the individual becomes responsible for the outcome, sharing the same objectives, but on a small scale. If each individual achieves his/her goals, the company will reach the number of sales for new clients.

The main purpose of this exercise is to ensure the strategic goals are unfolded into key indicators, aligning organizational and individual goals. It is important to train people in the process and provide employees with tools to achieve their targets, hence the company targets. Robust KPIs will provide predictability and stability of results.

 

 Performance Management & KPITalita Queiroz is a business consultant at Fernandez Young LLP and assists clients in improving their performances through KPIs. Due to her training and experience, Talita also works with Strategic Planning, Business Plans, Research, Financial Analysis, and Process Modelling.

The Pacific Alliance – Discussions with Australia

This month, Canada will be having discussions with Australia “to negotiate a free trade agreement with the Pacific Alliance members as a bloc.” Read more from the Canadian TCS.

Great Management comes from Great Business Planning  

leadership2It should go without saying but many business owners fail to see that great management is derived from great business planning.
Planning entails juggling resources and priorities in an orderly fashion, whereas management is a leadership role tied in with the overall productivity of the business. The two are intrinsically linked and cannot be easily separated. You can have some great people in a leadership role to manage your operation, but if you don’t have a road map, what exactly are they going to manage?
So, how does one go about ensuring that there is great management with an even better business plan?
First and foremost you need to have a vision and no, we’re not talking about vision boards and “down the next ten years I want” sort of thing. This strategy needs to be one where you think about what the objectives of your business are and who are the best people to help you reach these objectives. They are little nuances in the daily operation of your business, not vague futuristic ideas. Furthermore this vision needs to be communicated with your employees and other actors in your business (financial, administrative, contractors). Do not keep everything in your head, write it out, sort it out and plan in out: maps work best when you make the picture not envision them.
While you’re creating your map, start to define your long term goals. Remember, be specific, not vague. Set out milestones that you are determined to achieve, keep them realistic but also challenging. Do not just look at being in the black and out of the red, look at presence, memorability and engaging in your business. If you only look at the bottom line you might just lose the bigger picture and miss out on areas of improvement or even surprise areas of success.
Do you see character on your team? People who are shaping up to be real assets and have the potential to enhance your business with their ideas and innovations? If you do then you need to understand how to best utilize them. Let them lead, make sure your team is committed and willing to put in the effort, and if they are passionate about your vision and long term goals they will most definitely be the best option in your businesses long term success. Great management feeds off of a great business plan and in that sense a great business plan looks to have a great team of leaders making the plan into a reality.

 

Vancouver: A Gateway to Asia

vancouver-duskBrian Hutchinson’s article in the National Post goes in depth to discuss the recent phenomenon of affluent Asians congregating in Vancouver, BC- Canada; bringing with them various changes in the economy and local culture.

Along the Pacific Rim, British Colombia has grown integrated with Asia in terms of investment and immigration received from the continent. Chinese money brings with it support for local businesses and boosting local employment. Gone is the profile of a middle class Chinese immigrant striving to obtain the “North American Dream”, instead these newcomers arrive with ample money in their pocket, and ready to spend it.

From 2005 to 2012 according to Statistics Canada thirty-seven thousand Chinese millionaires have arrived in B.C as permanent residents under the Immigrant Investor Program – a Federal Initiative that acts as a gateway for wealthy immigrants to expedite their entry into Canada via low-interest loans given to the provincial government.

Vancouver, B.C has become an investment hub and a gateway to the Asian market, bridging communities, cultures and most importantly, ample capital.

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