‘Simplistic’ or ‘Holistic’ Business Valuation? The Difference is Chalk and Cheese!Tuesday, 23rd November 2010
Everyone thought the world was flat until they discovered it was round. Everyone thought the moon was made of green cheese until Neil Armstrong took a bite. As Henry Thoreau said "Things do not change; we change."
With family business, this is best reflected in the huge differences between the old paradigm of ‘Simplistic’ Valuation (think flat world, green cheese) and the new paradigm of ‘Holistic’ Valuation (think round world, Neil Armstrong). Changing from one way of valuation to the other makes a huge difference!
The old paradigm: Simplistic Valuation means looking backwards.
First, let’s look at the old traditional method, what I call ‘Simplistic Valuation’. For as long as I can remember the valuation paradigm has been based on a simplistic formula using multiples. Common examples are multiples of things such as EBIT (Earnings Before Interest and Tax), EPS (Earnings Per Share), ROE (Return On Equity)... the list goes on and on until it becomes like Forrest Gump’s box of chocolates: “You never know what you’re gonna get”.
It’s either backwards looking or concerned only with the present, and desperately limited in its ability to gauge the true worth of the future of a business. Last year’s earnings can never be a real indication of the dynamic revenue opportunities the future may hold. Last year’s return on equity can never be a gauge of the impact that new products in the pipeline may have on the value of a company’s brands.
Then there’s the big question: how can you apply the same ‘off-the-shelf’ solution to value two businesses that are completely different, and expect to get an outcome that is equally rigorous for both? The answer is that in most instances you can’t.
Simplistic Valuation traditionally is used to establish a value for the sale of the business. It serves no purpose other than that. And it’s often very questionable whether it works in favour of the owner. In fact, I would say that in many instances, Simplistic Valuation based on multiples results in under-valuation.
The new paradigm: Holistic Valuation means looking to the future.
In stark contrast to the old way, Holistic Valuation is a revelation that goes to the very core of what valuation really means. It is based on the principle that the real value of a business comes not from a performance statistic... it comes from a complete understanding of the DNA of a business and how it operates. To do this, you have to determine a company’s cash flow and balance sheet at a high strategic level.
By completely understanding everything from its management style to its competitive position in the marketplace... from its products to distribution systems... from market opportunities to new products being developed... from its customer base to its management and employee stability... from supplier relationships to technological currency... anything and everything that makes the business what it is.
In fact, Holistic Valuation means determining a dollar figure largely through non-financial considerations. And in my experience, in many instances Holistic Valuation results in a higher valuation than a Simplistic Valuation method.
For one of our clients, an IT company, this proved to be the case. During a Holistic Valuation for the purpose of sale negotiations, it became clear that a valuable part of the business was not of interest to the purchaser. This enabled us to carve it out for retention without affecting the value of the core business... thereby achieving a significant increase in overall valuation.
That’s what being a fully integrated business is all about.
It follows that if all manner of business management factors actually determine value, then management can have the greatest impact on value by doing them better. That’s how it works! Holistic Valuation is the tip of the iceberg... the rest of the iceberg is made up of how the business is managed and the effectiveness of all the facets of its operation.
Our approach to Holistic Valuation is an extension of our philosophy that with any family business, each and every decision, no matter what it applies to, should be part of an integrated plan which is totally comprehensive and gives a clear and co-ordinated pathway to the immediate and the future.
So my advice to clients in most instances is to forget about simplistic valuation formulas... the valuation of your family business is really a number at the end of an operational management philosophy.