How Do Buyers Put a Value on Your Company?

Jan 30, 2022

The Discounted Cashflow Method

Owners often have the misconception that their brand, their customer list, or their inventory is what a buyer is buying. In Actuality, buyers don’t really buy those things. What buyers actually care about is your future stream of profit – that is what they are actually buying, and how they value your company – how much profit they expect to make in the future.

So the value of your business comes down to 2 questions:

“How much profit will your company generate in the future?”
“How reliable are those estimates?”

This is how we make ALL of our investment decisions.
I’m going to show you the math a buyer is going to do so you are in a really good position to negotiate. The method they use is called Discounted Cashflow. It’s a relatively complex form of valuation with a lot of nuances that I won’t get into here, but what I want you to understand is the theory behind discounted cash flow because I think it gives you all that you need in terms of levers to pull when driving up the value of your company.

Imagine for a second you’re going to buy an asset that you think a year from now is going to be worth $100,000. If you expect a 15% return on your money, you’ll be willing to spend $86,957 today for an asset you expect to be worth $100,000 a year from today. That’s very simple math, you take $100,000 and divide it by your expectation for rate-of-return = 1.15, representing 15%.

So, $100,000 / 1.15 = $86,957

The same math holds true when a buyer is buying your business. That is how they value your company. They are going to ask you “How much profit do you expect to make next year” and then they are going to place a value on what that profit is worth to them in today’s dollars. They’ll arrive at that based on their expectation for Rate-of-Return is for buying your business.

In our hypothetical example here, we are going to assume the buyer is expecting a 15% return on their money, and this hypothetical seller company expects to make $100,000 in pre-tax profit.
Now one of the nuances about selling your business is that your business is likely to make money not only next year, but the year after that, and you as the seller is going to want to be compensated not only for year 1 profit but also year 2 profit and so on. So to arrive at what a buyer is willing to pay today for your profits 2 years from now, they are going to divide your profit expectations by 15% twice because they have to wait 2 years for the money. Now the math is:

($100,000 / 1.15) / 1.15 = $75,614.
So that year 2’s profit of 100k is worth $75,614 today.

They are going to project out into the future your stream of profits and then discount that back based on the number of years they have to wait to receive that profit. So you can see (in the image below) the profit 1 year from now of $100k is worth $86,957 and a $100k profit 10 years from now is worth $24,719 today because they have to wait 10 years for the money.

Then to arrive at what your business is worth to them, they are going to simply SUM the right-hand column. So in this example, if you add each of those rows up, you arrive at $501,878, or around 5x profit.

Understanding how we value your company will put you in an extremely advantageous position to increase the value of your business over time. So then whenever you are ready to exit, you have a very clear understanding of your approximated valuation, and a stronger negotiation position.

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