How to accurately calculate a company’s value

The Value of Nothing – How to accurately calculate a company’s value

Words from one of Oscar Wilde’s plays, Lady Windemere’s Fan, have often come to mind during my 25 years in finance and business.

Wilde writes about two 19th century upper-class Englishmen discussing the intrinsic nature of short-sightedness and cynicism:

Mr. Cecil Graham asks, “What is a Cynic?”

Lord Darlington replies, “A man who knows the price of everything, and the value of nothing.”

To which Cecil Graham quickly responds, “And a Sentimentalist, my dear Darlington, is a man who sees an absurd value in everything and doesn’t know the market price of any single thing.”

The value of something can be vastly different from its price

In business, as in personal life, the value of something can be vastly different from its price.  When advising business leaders on corporate valuation, I found that they often misinterpreted price for value. Unfortunately, this often results in companies being bought and sold at prices that do not reflect their real market value.

Perhaps, in order to determine a buy or sell price, you have been involved in a “value audit” of a company’s operations. These audits parse a company’s performance numbers in excruciating detail, analyzing current and projected sales, return on sales/equity/debt/assets, debt load, inventory turnover, and debt-to-equity. They also consider the alignment of product with the needs, wants, and projected growth of the market. Supply, fulfillment, and operating performance numbers are carefully reviewed. This analysis then yields a price, which is later negotiated. As you can see, there is no sentimentalism here, with everything based on concrete numbers.

However, Lord Darlington is right. These calculated prices may only dimly reflect the company’s actual value. We have all been shocked by the prices paid for some companies. There have been sale prices that far exceeded or fell incredibly below an industry’s normal pricing multiples, even though financial analysis would have suggested otherwise. In such cases, buyers and sellers might have actually negotiated value, rather than price.

Don’t overlook factors crucial to a company’s sustained success and value

A few years ago, I was asked to help restructure the operations of a technology company that had just been purchased by a venture capital firm. Even though they had carefully completed due diligence on the company’s financial and operational performance prior to negotiating price, it soon became obvious that the company’s value to the new owners was far less than the price they paid. Why? Because they overlooked factors crucial to a company’s sustained success and value:

The Right Team: Does the company have the best possible leadership, management team, and workforce to effectively execute the corporate strategy? 

The Right Skills: Does the workforce really have the skill set to tackle the challenges to come?

The Right Culture: Is the company culture healthy, with high morale? Does it support individual initiative, innovation, growth, and respect for other team members? Do team members feel that their roles are valued?

The Right Communication: Is there clear, meaningful, open, and normalized communication among the company teams to ensure continued learning and individual accountability? Does every team member understand and support the corporate purpose, vision, and mission?

The Right Assets: Will the technology and physical assets meet present and future operational demands?

The Right Structure: Do the company’s operating and organizational structures align with its corporate vision, strategy, and business model?

Had the venture capital team included these fundamental factors in its evaluation, it would have offered a significantly lower price, or not have submitted an offer at all. In other words, to accurately calculate a company’s value, considering the financial and operational numbers is necessary, but not sufficient.

 

Looking beyond the traditional numerical due diligence parameters allows buyers to best calculate the true value of a company to them and sellers to justify a higher asking price.  In Lord Darlington’s terminology, it is essential to fully understand a company’s value before you can determine its price.

 

 

Article written by Paul Hager, Partner – ONEtoONE Corporate Finance USA.

Want to read more about companies value and due diligence? Have a look at “WHEN YOU LIE SELLING YOUR BUSINESS.”

Leave a Reply

Your email address will not be published. Required fields are marked *