Most business owners don’t have a lot of experience with corporate value. They are too busy working in and on their business. And valuation can seem to owners like an esoteric financial exercise. But they know it’s important. And, as their trusted advisors, it’s incumbent on us to help them understand it.
Valuation Basics and the Subjectivity Challenge
There are two related ways that companies are valued. Both rely on accounting data:
- Multiple of Earnings: This approach is a shorthand formula people often use to talk about valuation. It summarizes the expected valuation as a multiple of EBITDA (and sometimes as a multiple of revenues).
- Calculated Value: This is a more complex way that involves projecting the company’s financials into the future and using a discount factor to calculate the present value of the future expected cash flows in the projections. This approach is needed for formal purposes like taxes and equity plans.
Both the shorthand and calculated models start with historical financial data which is reliable thanks to the work of our accounting brethren. So valuation can appear to be very “scientific.” How does subjectivity enter the process? Projections involve a lot of assumptions. And both the multiple used in the shorthand version and the discount factor using in calculated valuation are subjective metrics. These metrics may be based on market data, risk evaluations and highly educated analyses. But there is considerable judgment interjected on the part of person doing the valuation, which is why the calculated value generally requires a professional valuator. Of course, ultimately, the true value of a company is what a buyer actually pays. We’ve all heard the saying “beauty is in the eye of the beholder.” This is absolutely true of corporate buyers. Different buyers see and value different things in a business and will come up with a different offer. It’s what makes markets dynamic.
Subjectivity Has Grown Over Time
It wasn’t always quite as complicated. Our current accounting model was designed in the industrial era where hard assets dominated. For more than a century, there was a strong correlation between corporate value and the net value of the tangible assets on a company’s balance sheet. Into the 1980’s, 83% of the value of a business was visible on its balance sheet.* Consumers of the financials could literally get a sense of a company’s value by seeing the accounting for its hard assets.
But with the rise of information technologies, the internet and, now, AI, most corporate value elements have moved off balance sheet. Today, 90% of business value is intangible and often completely excluded from the balance sheet.* You can’t see the drivers of value. This is because the accounting model doesn’t allow many new kinds of “assets” to be capitalized on the balance sheet. The productive resources driving company success have become more and more invisible. The consequence is a giant intangible information gap.
What Are the Intangibles Driving Value?
The answer to understanding productive “assets” of a company lies in this three-part corporate value creation formula: How can our company create value for its customers in a way that also creates value for our organization and its external stakeholders?
Breaking this down further, you can see that most of these value creation factors are intangible and/or off-balance sheet:
- Customer Value – Customer relationships are mostly intangible (exception: sometimes are capitalized in a corporate acquisition)
- Organization Value – Financial and hard assets are tangible. Strategic and knowledge assets are mostly intangible (exception: sometimes patents and software are capitalized)
- Stakeholder Value – Relationships with employees, suppliers, communities and the environment are mostly intangible (exception: natural resources that can be owned)
This list gives you a good sense of the size of the intangibles information gap that contributes to the high degree of subjectivity in valuation.
Closing the Intangibles Information Gap
You can help your clients close this gap by helping them see, manage and tell the story of their full value creation system:
- Create a unified system to measure and manage all the value creation elements in a unified, consistent way:
- Create process maps and visualizations about how all these value creation elements fit together
- Make sure the organization’s internal stewards of each kind of capital are identified
- Identify, track and work to improve key metrics for each element
- Tell the story of this internal value creation system to external audiences like bankers, investors and potential acquirers.
The more detailed and “tangible” you can make these value creation elements, the higher the chance that your client can tell a compelling story that gets the best possible valuation. If you do your job well, your client will go from having an invisible black box filled with intangibles to having clear models and measures that show how and how well it creates long-term value. That’s a great start to getting the best possible valuation for their company.
About Insights7: Our AlignEX™ aligned execution hub helps companies unify strategy execution data and decision making. Advisors deliver their findings in our hub so they are immediately actionable for their clients. This causes a fundamental shift from advising to helping make change happen. Our platform is a great fit for consultants who work at either the process or the strategy level.
Let’s talk! We’ll start with your deliverables and map how these can become actionable in our system. Feel free to message me at XPX or connect and schedule with me on LinkedIn.
* Data source: https://oceantomo.com/intangible-asset-market-value-study/
