Do the number of valuation methods make your head spin? That’s a common reaction among owners looking to sell their business. Yet if you understand the three basic approaches to valuation, you’ll understand which type of valuation method makes sense for your business.
In this post, we were fortunate to tap into the expert on one of the most respected authorities on valuation in the world, Prof. Aswath Damodaran.
Meet Prof. Aswath Damodaran
Aswath Damodaran is a Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. As his biography on the Stern School’s website indicates:
Professor Damodaran’s contributions to the field of Finance have been recognized many times over. In addition to myriad publications in academic journals, Professor Damodaran is the author of several highly-regarded and widely-used academic texts on Valuation, Corporate Finance, and Investment Management.
But Prof. Damodaran is not your typical academic. Far from it. Watch this video – within the first seven minutes, you’ll find out how funny, perceptive and maybe even a bit subversive he is with his approach to teaching and finance.
What Lessons Will He Share?
While Prof. Damodaran does a great deal of his work assessing the value of publicly-traded companies, he was kind enough to share some insights on the fundamentals of valuation that can be applied to small and mid-sized companies in the printing and print-related industries.
In this post, we will define:
- Some myths about valuation, and what you can really expect from a valuation
- The three approaches to business valuation – and how they influence difference methods
- Valuation vs. Pricing and how it applies to setting a price for your printing business
Business Valuation Myths: Can You Really Produce an Accurate Valuation?
In his teachings on valuation, Prof. Damodaran starts by highlighting some of the myths of valuations.
Myth 1: A valuation is an objective search for “true” value
Prof. Damodaran notes that “all valuations are biased.” The only questions is ‘how much’ and in which direction. Further, he also notes that the “direction of the magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.”
That’s entirely why we encourage independent, third-party appraisals for each business valuation. Yet his point is well taken; bias can impact a valuation, and the idea that a “true value” can be measured is unrealistic.
Myth 2: A good valuation provides a precise estimate of value
Dr. Damodaran believes there are no precise valuations, and that the “payoff to valuation is greatest when valuation is least precise.”
The reason is simple. When there is a great deal of uncertainty about the future, most people give up on doing valuation, choosing to follow what others are doing. Thus, someone who values a company in this environment is going to have an advantage over others in the market. The more certain the future becomes, the easier it becomes for everyone to value the company.
Myth 3: The more quantitative a model, the better the valuation
Your understanding of a valuation model is inversely proportional to the number of inputs required for the model. He notes that “simpler valuation models do much better than complex ones.” Complex models require more inputs and those inputs have to come from you. The error in the inputs often drowns out the precision that comes from being complex.
Many Different Business Valuation Methods, But Only Three Approaches
As we noted in the beginning of this post, there are countless methods for establishing a business’s value.
With a nod to Prof. Damodaran’s views on simpler valuation models, it’s more important to understand the three overall approaches to valuation. Once you’ve grasped these concepts, you can understand the particular method being used.
Intrinsic Valuation
With this method, you’re really looking at what truly makes up the value of your company, and projecting how the future will impact that value.
Essentially, intrinsic value “relates the value of an asset to its business characteristics: Its capacity to generate cash flow and the risk in its cash flow.” Also referred to as “discounted cash flow valuation,” it “forces you to think about underlying characteristics of the firm, and understand its business.”
Relative Valuation
The “market perceptions and moods” are reflected in this approach, as compared to the intrinsic valuation. This is used when your objective is to “sell an asset at that price today” and invest on the “momentum” based strategies.
With the current state of the market taken into account, Prof. Damodaran notes that “there will always be a significant proportion of businesses that are undervalued and overvalued.”
Contingent Claim Valuation
In the third approach, you analyze assets. This method may be used where you’re liquidating a business; valuing a business’s assets for accounting reasons; or using a “sum of the parts” valuation, in which someone is using targeting an acquisition as a “cheap investment.” We see it in truck-in transactions.
Business Valuation: Is it in the Eye of the Beholder?
Prof. Damodaran notes the three approaches can produce different results. “The three approaches can yield different estimates of value for the same asset at the same point in time.”
It all depends on the intent of the valuation and how it’s being used to justify the price.
It’s also calculated in reaction to the market place. Again, Prof. Damodaran:
“The use of valuation models in investment decisions (i.e. decisions on which assets are undervalued and which are overvalued are based upon:
- A perception that markets are inefficient and make mistakes in assessing value
- An assumption about how and when these inefficiencies will be corrected
In an efficient market, the market prices is the best estimate of value. The purpose of any valuation model is then the justification of this value.”
In other words, don’t think of the valuation model as setting the price. The market sets the price. The valuation helps to justify it. We noted this when we discussed it in the previous article – the multiple you can charge is not as much based upon the marketplace as it is upon your own internal performance.
Which Business Valuation Approaches are Used for Printing Industry?
The business valuation approach you’ll use is largely dependent on your strategy. “There is a time and a place for each approach,” Professor Damodaran notes, “and knowing when to use each one is a key part of mastering valuation.”
What we see typically is the use of the Intrinsic Value for most companies in the printing and print-related industries. In order to demand a higher multiple, you need bigger margins.
As Darren Mize noted, “Like most companies, printing companies become more valuable with higher margins and smaller asset turnover (meaning doing more with less) – the larger companies don’t necessarily equate to higher value. Back in the early 2000’s printing companies were hot and selling for large multiples but today they have come back to the pack.”
In growing sectors, the Relative Valuation might be more applicable. Smart labeling technologies (the subject of an upcoming post) might influence a business valuation, for example.
Prof. Damodaran echoes Darren Mize’s statement. “I have no idea what that multiple would be a printing business, my guess would be that if margins are your key differentiator across companies, it would be a revenue multiple.”
Indeed, EBITDA, at the end of the day, still seems to be the primary factor in what moves the dial for investors. So how do you sell an investor on your future value as well?
It depends on your vision, your marketing strategy, but most importantly, how many clients you have locked into long-term agreements, or “multi-year contracts” as Vince Mallardi, CMC. PBBA International, “Find the tangible bottom line. After that, the only thing you have is your contracts.”
Even if the buyer will have to discount the cash flow into net present value, those multi-year contracts can be extremely valuable to a buyer.
What Comes First: The Price or the Valuation?
In reaching out to Prof. Damodaran, he pointed out that we were really inquiring more about pricing methods, and less about valuation methods. Valuation can be used to justify the price you ask, and the strategic way you price your company will ultimately boil down to one of the three approaches listed above.
At the end of the day, the biggest pricing – and valuation mistakes – occur when you’re not aware of the current state of your company. “The biggest mistakes are the same for large and small companies,” Prof. Damodaran warns, “It’s not controlling for difference in profitability, growth and risk.”
We leave you with one last video of Prof. Damodaran as he discusses the Bermuda Triangle of Valuation. Enjoy.