Producers | Consumers

But that’s not really an equation at all. An equation with producers on one side and consumers on the other would look like this:

Producers = Consumers

Producers on one side, consumers on the other. Find things you want to buy, and if it’s not there, then build it. If you produce something you want, you are both the producer and the consumer. Immediately a feedback loop is created. You’re also building something that is already sold to at least one person, and hopefully if you want it, you know of few other people who want it. This may not be so important if you have established yourself as a businessman with lots of experience, but as a first time entrepreneur you’re going to face more challenges related to inexperience and mistakes. To make up for this you’ve got to have the passion and understanding of the product that will allow you to put your head through brick walls and forge ahead.

Invest in Top Performers

So where should you invest your resources? The natural and most logical answer is to invest in your bad performers to try to bring them up to speed. But this isn’t the right answer. The right thing to do is to invest in your top performers. 80% of results come from 20% of your assets. You get the highest rate of return from your top performers, so this is where your resources should go. If you invest in your bad performers, it may help get them up to speed in the short run, but they will eat up those resources and eventually fall behind again requiring even more investment. Studies have proven that money invested in top performers can have a rate of return many times greater than the same investment in poor performers.

Grow Your Personal Strengths

The same goes for personal growth. The focus of your efforts should be in improving areas you are already good at. You can improve your personal value much faster if know your natural strengths and specialize than if you try to bring your weaknesses up to the level of your strengths. This is the concept of competitive advantage on a personal level.

Maximize Your Strategic Advantage

The concept of competitive advantage also applies to business strategy. If you want to be competitive, you have to know what you do best and do it even better. You can’t be all things to all people. As Michael Porter suggests, you should maximize your competitiveness in the areas you have a natural advantage, and minimize the rest.

Be Local

When Wal-Mart came to Canada they changed the star in the middle of the name to a maple leaf and all the commercials said “working hard to be Canada’s Wal-Mart!” I’m sure they spent zillions on trying to establish themselves as brand Canadians would accept. Years later, I took a survey of 1 million Canadians and only 1 person said they felt proud to shop at Wal-Mart because they were supporting a truly Canadian business. Ok, I actually only surveyed one person, and that person was myself, but I didn’t think Wal-Mart was distinctly Canadian, so the results were still the same. No matter how smart, big, and powerful they are a big business cannot compete with you if you establish yourself as a small and local company. You are small and local by nature, so just go with it.

Respond to Your Customers

I used to be a big fan of Sony. They have cool products and a cool image, and whenever I called them they were pretty helpful. But they took away my favorite product, the Clie. So I called up Nobuyuki Idei (who was the CEO at the time) and he told me that sorry, the Clie ran into some legal issues with Palm and they couldn’t produce it anymore, but he had a few in the warehouse and he’d send one over to me. This story isn’t completely true. Actually I just lost interest in Sony and bought a smart phone that took an SD card instead of a Memory Stick. Then I bought an HP computer, and then a no-name mp3 player that took SD cards, and now I could care less if I have a Sony anything. It’s not Sony’s fault, they were just too big to react quickly to my needs. Small businesses can avoid this problem if they want to.

Don’t Be a Sell Out

Unless you’re name is Mic Jagger, it’s pretty hard to be big and powerful without being a sell out. I for one would sell out in a heartbeat, but until I have that opportunity I’ll make sure every knows I’m underground and in touch with the common people. It may even be a good idea to give to charity just to prove you’re not all about the money. After you get rich and fat you’ll enviably lose you underground appeal, but then you’ll be rich and fat, so who cares.

Don’t Be Evil

Ok, this is Google’s mantra, and you can’t get any bigger than Google. But making it you’re mantra isn’t enough. If you’re bigger, then you’re eviler. People are suckers for the David and Goliath story so you should leverage that blind love. Case and point: Apple—evil. But who would ever pick on the poor little company with 5% market share? Apple has shamelessly milked their underdog status from the beginning, and you can too! It also helps these days if you play it off like you’re socially responsible.

More:
5 Ways to Value a Private Business

Adjust for Non-Cash Item

You get cash from either the statement of cash flows in the operating cash flows section, or from the income statement by removing non-cash items. The problem with removing non-cash items like amortization is that you lose the anticipated costs that they represent. You’ve got to be aware of this when you are using this method and take it in to account. For example, you could add on a capital asset replacement cost when forecasting future cash flows to compensate for the loss of amortization.

Find a Discount Factor

A discount factor is like an interest rate. If there was no risk, the discount factor would be the same as an interest rate. But it’s more difficult to find the discount rate for a business because there is varying amounts of risk. The method of finding a discount factor is outside the scope of this post, but for reference, you can look at Investopedia for a general introduction to finding this.

Simplified Method – Average Cash Flows

You can just average the out the annual cash flows and divide it by a discount factor. This method assumes the value of the business is can be represented from one cash flow.

Advanced Method – Yearly Cash Flows

The cash flow method of valuing a business involves forecasting cash flows and determining the present value of those cash flows. An investor might use this method when looking at a startup because he can use the forecasted cash flow statements. This method is risky because it is not usually realistic to expect to predict annual cash flows in the future because there is so much uncertainty. You should never go out any further than 5 years because after 5 years the predictions are generally worthless.

More:
5 Ways to Value a Private Business

Earnings / Cap Rate = Value of Business

You need to identify 3 things to value a business this way: The earnings, the cap rate, and any irrelevant assets on the statements.

Normalize Earnings

Finding earnings is not as simple as looking at the net income on the latest income statement. Quite often the latest reported earnings are not the normal earnings. You need to look carefully at the income statement and historical statements to try to approximate normal earnings. For example, an owner of a business may be drawing abnormally large salaries for himself for tax purposes, or perhaps he may have not paid himself for a few years to make it look like the business is earning because he anticipates selling it. You can look at net income, income before taxes, EBIT, or EBITDA. Be sure to use what is typically used in the industry so you can compare accurately. Use your judgment on the circumstances to either calculate an average of the past 5 or so year’s normalized earnings, a weighted average that favors recent years, or just the most current year’s earnings.

Choose a Cap Rate

The cap rate, which is like the inverse of a discount rate, is kind of like the interest rate on an investment. Choosing a cap rate is tricky. All business students spend an entire semester banging their heads on their desks trying to sort out this concept. I’m not going to even try to go there again, but for a reference when needed, here’s Investopedia’s attempt at explaining it.

The basic idea is the more risky the business, the higher the cap rate. If earnings are net income, cap rates are usually about 12% to 25%. If earnings are EBIT then maybe the cap rate would be 20% to 33%. You can also look to the industry for an idea of what cap rates might be.

Consider Irrelevant Assets

When a company is put up for sale, the seller will want to be paid for all the assets. But some of the assets may not be producing income or may not be related to the business. Look through the income statement and balance sheet and see if there is anything there that is not related to the business the purchaser intends to own or operate. For example, a restaurant may own an entire building that is not being used, but still including the value of the building in the sale price of the business. Even if the building is generating income through rent, this is not the same business as the restaurant business and will need to be evaluated as two separate businesses.

More:
5 Ways to Value a Private Business

Use EPS and PE ratios

It’s common to try to use the P/E ratio for the particular business sector the company in question is a part of. You might get this from the FTSE Actuaries Share Indices in the Financial Times. You can then apply that ratio to the metrics of the private company, such as the EPS, to get a rough estimate of the market price of the company’s shares. A formula could be:

Industry P/E *Specific Company EPS = Price per Common Share.

Use Price per User

Subscription based industries, especially High Tech, might estimate how much money each user is paying to the company and use that information to value the company.

Use the Position of the Purchaser

Sometimes the purchaser of a company gains some additional value because of economies of scale, additional sources of revenue, access to new markets, or synergies. In this case the value of the company being purchase is probably higher than it would be if the purchaser was new to the industry.

More:
5 Ways to Value a Private Business

Process

If you add up market values of all the assets and subtract off the liabilities then you will (hopefully) have something left over, which is the owner’s equity and the value of the business according to this approach. You would also need to subtract off any disposition costs such as real estate or legal fees. The other way to do it is to take the equity section of the balance sheet and add or subtract the differences between the historical numbers (reported in the balance sheet assets and liabilities) and the market values.

Formulas

Market Value of Assets – Liabilities – Disposition Costs = Shareholders’ Equity = Value of Company

Or

Shareholders’ Equity (from balance sheet) +/- Market Adjustments for Assets and Liabilities – Disposition Costs = Value of Company

Useful For Full Takeovers

Since it takes time and money to figure out the market values of all the assets, this approach is not realistic in most cases. The only time this approach is generally used is when one company or person is taking over another company in its entirety.

Useful for Asset Heavy Businesses

This approach may make sense if the business’s value is mainly in the assets, like a corner store. It wouldn’t make sense for something like a consulting company where the value is mainly in the expertise. However, it may be accurate if the expertise won’t be transferred with the company. For example, a one-man consulting company would only be worth the net market value of the assets if that one consultant was leaving with the sale of the company.

Goodwill

Goodwill is the amount of value in the company or brand that is not reflected in any material assets. It could be the value in a trademark or location or something like that. In this approach goodwill is not taken into account. It is common for small business to be valued using this method only and if some amount of goodwill to be added if appropriate.

More:
5 Ways to Value a Private Business

Net Assets

This is a very basic approach that looks at the market value of items on the balance sheet for find the fair market value of the net assets, which is considered then the value of the business. It can be costly and time consuming to find the market value of all the assets, so it’s usually only used in a takeover of the entire company. It doesn’t make sense to do it if the businesses value is not mainly in the assets.

Market Based

The market based approach is a highly subjective method that attempts to use information available from open markets to help estimate the price of the non-traded shares. It often looks at similar publicly traded companies and attempts to apply their metrics to the metrics of the private firm.

Capitalized Earnings

The capitalized earnings approach is almost always included in the valuation process. This approach uses the philosophy that a business is worth what it will earn. The concept involves taking normal earnings and dividing it by a cap rate (discount factor). The tricky parts are determining what normal earnings really are, what assets are really parts of the business, and especially choosing an appropriate discount rate, which varies depending on the amount of risk involved.

Cash Flow

The cash flow approach uses a cap rate (discount factor) to figure out the value of the company using cash flows. This can be done by finding an average cash flow and dividing it by the cap rate or by projecting yearly cash flows and discounting them using the cap rate to determine the present value of the cash flows. This could be used to get an idea of what a startup company may be worth.

Gross Revenue

The gross revenue method assumes everything is reflected in the last years gross sales. Some factor associated to the industry is multiplied by the gross sales to get the value of the business.

Earnings per share (EPS)

[ (Net Income – Preferred Dividends) / Number of Common Shares ]

Because the number of shares is not known, this ratio actually doesn’t mean anything on its own unless you related it to the Price Earnings ratio below.

Price earnings ratio

[ Market Price per Common Share / EPS ]

This ratio will be compared to the P/E ratio for the industry to see how profitably investors expect this company to be. Higher means that investors are expecting higher returns, but of course it is more risky because there is more to lose. For private companies, this ratio can be used to ballpark (very roughly) the share price of the business. Use the P/E ratio for the particular business sector (get it from the FTSE Actuaries Share Indices in the Financial Times) and multiply it by the EPS to get the Market Price per Common Share.

Return on Assets (RoA)

[ (Net Income + Interest After Tax) / Total Assets ]

This ratio is used to see how profitable the assets of this company are. If there is a low RoA, it may indicate that the business has high capital intensity, which means higher up front investments.

Return on Investment Capital (RoIC)

[ (Net Income + Interest After Tax) / (Equity + Long Term Liabilities) ]

This figure shows how much all the guys on the right side of the balance sheet (investors, creditors, shareholders, etc.) are getting on their investment. It will be compared to the industry.

Debt to Equity (D/E)

[ Total Liabilities / Equity ]

This ratio gives an idea of the capital structure of the business. Of course a high ratio indicates that the firm is highly leveraged, getting more of its funding from debt than equity.

Debt to Capital (D/C)

[ Long Term Liabilities / Long Term Liabilities + Equity ]

This is just another way of looking at the amount of debt compared to equity. A higher ratio might indicate a weaker position because of the cost of debt.