Price vs Value (Part 2)

Price refers to the negotiated amount in a transaction.  But Price doesn’t always mean Value.

A valuation is a mathematical process conducted in a ‘notional’ market based on assumptions regarding the economic and industry conditions, and the business characteristics, including the relative profitability of a business, the underlying value of the tangible and intangible assets of the business and the market perceptions of similar businesses.  Every valuation completed by Troy Valuations considers each of these factors.

Economic and Industry Conditions

Capital Markets

Capital market conditions mean the ease of access to capital.  Is money cheap or is it expensive?  In 2022, Canada and the US have seen an increase in interest rates.  You can think of interest rates as the cost of money.  Money has become more expensive than it was one year ago.  The value of money has also declined in 2022.  Both Canada and the US have seen increasing rates of inflation.  Inflation means that the same amount of money can’t buy the same amount of ‘stuff’ that it could one year ago.  As a result of these changing economic conditions, savers (those with money) are looking for a better return on their investments (those who need money).

Industry Conditions

All industries are changing all the time.  What is ‘hot’ today may be tomorrow’s ‘dog’.  Take cryptocurrency for example.  One year ago, the price of Bitcoin was USD$43,000; currently Bitcoin is trading around USD$22,000.  Investors purchasing cryptocurrency companies in August 2021 may be regretting their investments in August 2022.  If the price of Bitcoin should increase in the future, buyers of crypto companies today will be happy.  Early adapters take industry risk into account and have long investment horizons.

Business Characteristics

Cash Flow

How much cash does the business make?  Cash is the amount a business has after paying all the expenses in any given period.  Cash can be deployed into more assets.  Cash can be sent out to repay lenders or pay shareholders through a dividend.  Or cash can be retained in the business, as cash, for future use.  The amount of cash generated in a business during a time period is known as cash flow.  Cash flow is what creates value for the business and its shareholders. 

The greater the amount of cash flow, the greater the value.

Asset Value

Every business has assets.  Some you can see and touch, known as tangible assets.  These are the assets whose values are typically recorded on the balance sheet.  These are the account receivable, inventory, vehicles, computers, equipment, etc.

Businesses also have intangible assets – assets that create value but are not generally recorded on a balance sheet.  Intangible assets can be identified – such as a patent, trademark or a secret recipe.  Think of KFC: there are eleven herbs and spices that flavor that fried chicken, but no one, except the Colonel, knows exactly what these are!  Unidentifiable intangible assets are grouped together in one bucket called goodwill.

The value of the assets, both tangible and intangible, will drive the value of the business.  The greater the asset value, the greater the business value.

Market Pricing

Economists don’t agree about much, but they do agree: open markets provide price signals.  Prices send signals and provide information for buyers and sellers in ways that calculators could never capture. Price captures information that may not be explicitly disclosed but is known or present in a transaction. 

In a publicly traded stock market, the price of the stock reflects investors knowledge of the business’ history and expectations of future performance. Similarly, a business’ value can be determined using the price signals from previous transactions of similar companies.  Business owners will tell you that they bought the business at 3x cash flow or 1x revenue.  These are pricing signals that indicate the value of the business.

The higher the price signal, or metric, the greater the business value.

Valuation Opinion

An expert opinion of value is one that is based on evidence and data, studied from multiple approaches, using a described standard of value at a date, considering the circumstances of the business and the economic environment in which it operates.

What is the value of your business?  If you sold your business, what could you get for it?  These are good questions to ask but are difficult to answer. Uncertainty has risks. Call Troy Valuations to reduce the risk in your transaction.

Check out Price in Part 1.