Contibuted by: David Coffman

From where does the value of a business come? Like any investment, business value is a function of the returns a business generates and the risks associated with owning it.

Returns

The returns from a business are generally measured by its ability to generate earnings (earning capacity). The value of a company that does not have earning capacity comes primarily from its tangible assets.  

Earning capacity is not just net profits or cash flow. Financial statements and tax returns do not reflect economic reality. They must be adjusted to compensate for accounting principles, tax regulations, and related party dealings that do not accurately portray what really happened.

Earning capacity is not created in one year. A company must build a history of generating earnings consistently. Trends should be analyzed, and unusual or non-recurring events should be eliminated. These events can sometimes be the accumulated effect of incremental changes, so don’t be too quick to factor them out.         

Value is not created by an earning capacity that is just average. A company can only create value by exceeding the earning capacity expected by industry or intrinsic benchmarks. The earning capacity of a business can be used to value the entire entity or just its intangible (goodwill) value depending on the valuation method used.

Many small businesses don’t earn enough to create value. Their earnings often do not provide the owners with adequate compensation. Some of these companies have existed for decades, have an established customer base, and have excellent reputations. Their owners have worked hard to build the business to its current state, but they lack one important thing – earning capacity. Without it these small businesses have little or no goodwill value. Intangible assets like loyal, repeat customers and a great reputation have no value if the owners can’t convert them into earnings. 

Risks

The many risks associated with owning a business can be separated into two types – internal and external. Factors such as management ability and depth, sales and marketing programs, customer base, financial condition, location, condition of facilities, and operating conditions must be considered to determine the internal risks. The competitive environment, economic conditions, industry trends, legal and political environment, and government regulation must be considered to estimate the level of external risk.

One of the biggest risks associated with a small business is its over-reliance on the owner. If the owner dies, becomes disabled, or sells the business, the risk that the business will be adversely affected is great. This risk is often so high that the business has no value other than its tangible assets. To reduce this risk owners must gradually make themselves less important to the business by delegating, and setting up systems and procedures.

Conclusion

Sooner or later the value of your business will become important to you. When that time comes the business that you put so much time, energy and money into may not be worth much, if you don’t start paying attention to what really drives business value – earning capacity and risk.

David Coffman is a CPA who is accredited and certified in business valuation. He has valued hundreds of small businesses since 1997. David has worked as a CPA and advisor almost exclusively with small businesses for over 30 years. He has started dozens of businesses since his early teens, and is a lifelong student of business.