Translated originally from Foco America magazine on 03/19/2018 By Abel Fiorot
The valuation process is used to determine the value of a business/project for several purposes: business buying and selling, judicial separation between partners (including divorce), determining the success of an enterprise or project, make investments (in the case of the stock market), trading off parts of the asset, among other situations.
Unlike to what many may think, the fair value of a company is directly linked to the future cash benefits that it can generate and not by their physical goods and quantitative assets registered by accounting. In other words, the fair value of a company cannot be determined by their wealth generated in the past, but by what it may generate in the future.
It´s important to emphasize that the value of a business is defined as the process of negotiation between the buying party and the selling party and that the fair value of a business, established by the valuation processes and methods, represents the potential value of a business due to the expectation of generating future results of enterprise or project.
There are several methodologies available to evaluate a business, from the established Discounted Cash Flow method to multiple of similar sectors and companies in the market. The world’s most prominent business valuation experts are here in the United States, including Aswath Damodaran, an esteemed and acknowledged finance professor at the Stern School of Business at New York University. In the process of business valuation, models and financial projections are used. It should be noted that no model provides a precise and unique value for a business, but rather an estimate of value. This is because decisions affecting revenues, costs, expenses, working capital, and investments, combined with changes in the economic environment, influence the results of the business and change their value.
The valuation models are essentially quantitative; however, the business valuation process contemplates many subjective aspects, inserted in the assumptions of such models. These assumptions must be carefully analyzed as they are critical to the quality and reliability of the results.
When a Brazilian entrepreneur evaluates a business opportunity in the United States, he must be aware of several factors. The main one is the correct identification of the value drivers of the business. You can make a correct valuation from the technical point of view and subsequently the business doesn´t achieve the projected and desired results. This can happen due to the risk inherent in the business world in general, but also by negligence in the management of some important value driver.
The value drivers vary from business to business, and their correct identification is essential for defining the price to be paid and subsequent business success. You cannot buy a commercial company that has a vast network of distributors and merely dismiss distributors. The dynamics and market access are different between Brazil and the United States. Despite having an open market, competition in the United States is fierce, and access to markets tends to be slower.
Another point of interest is the discount rate since it has an enormous weight in the final business valuation result. The discount rate is defined by the cost of capital of the entrepreneur, which can also be obtained using some asset pricing model. It is important to note that the discount rates used for business and companies in the United States are much lower than the rates adopted in studies conducted in Brazil for the same business sector. Remember that the cost of capital calculation needs to be adjusted according to the risk of the country in which the company is located. This makes a huge difference in determining the value of the business. The lower the rate, the higher the value and vice versa.
The effect of taxes should also be taken into account in the business valuation process. The American tax system is much more straightforward and uncomplicated than the Brazilian one, but this does not mean that the entrepreneur should fail to pay much attention to the aspects and influence of taxes on the cash flows projected by the enterprise. Some regions of the United States offer tax incentives for new ventures, and indeed the same must be considered.
The principal and most severe errors of business valuation are recognition of high rates of growth without investment, lack of recognition of the perpetuity when existing and incorrect rate of discount.
A correct business valuation is a critical success factor for anyone who wants to win in the competitive and great American market. In addition to being a valuable tool, being fundamental for the administration of the company.
Think about it!
As I always say: let’s go forward!