How to Value Your Business - Part Five

Let's now look at the most difficult, but the most economically-relevant way to value your business.  This is the discounted earnings approach.  The methods used in this approach include the discounted cash flow method, the single-period earnings capitalization method, and many others.

This approach and its underlying methods are based on the principle of economic substitution.  That's really just a short way to say that given a certain potential output and price, would you rather bet on option x or option y, given the risk of NOT achieving the expected result.

There are three variables to consider in any bet.  First, what is the amount I have to pay.  Second, what is the amount of the potential payoff.  Third, how risky is the bet (or what is the chance that I pay the price but don't get the amount of the payoff).

All three of these elements are interrelated.  The lower the risk, the closer the purchase price and the payout price are.  The more risk there is, the less the price is compared to the potential payout.  Furthermore, if you know any two of the three variables, you can (with simple algebra) derive the third variable.

Let's put this concept in investment terms.  US T-Bills are near zero-risk.  That's why the interest rate (risk rate) is near zero.  So, since you're almost guaranteed a 1% return with no risk of losing money, you're willing to pay more than, lets say, putting money into the latest sexy IPO like Facebook (FB).  If however you want to put money into FB, you want the chance to earn 20% on your investment, so the relative price has to be lower than a US T-Bill.  The downside is the risk that FB will not give you a 20% return.  The value you assign to this bet, then, has to equalize the risk between an almost guaranteed 1% return and a less-likely potential 20% return.  Under the concept of economic substitution, the correct price is where the amount you're willing to pay for a risky 20% payoff is the same as the price you'd pay for a more-guaranteed 1% return.

Under this method, we derive two values and solve for the third variable.  In this case, we have the risk variable (interest rate) and expected return.  We then solve for the third variable, the purchase price.

Although this method is the most difficult to understand, it's the most economically-defensible and is somewhat more formula-based than others.  There is much more to this method than can be explained here.  However, we invite you to contact us to better understand how to apply this method to valuing your business.  Please feel free to contact us to help you value your business.

B. Dane Byers, CPA, ABV, CFF
Bassett & Byers, P.A.
Partner
3701 Lake Boone Trail, Ste 201
Raleigh, NC 27607
(919) 303-1049
dbyers@bassettcpas.com