Valuing a Business Stupidly

Buying and selling a business, particularly a smaller one, rests on what its value is. Trouble is, some of the most widely used are very complex and end up wide of the mark. Based on sheer guesswork, these methods, particularly discounted cash flow, make the deals end in sorrow.I find it amusing when I hear about an acquirer using discounted cash flow as a method to value a targeted business. That’s when I know there is a very good chance the buyer will get a great deal and the acquisition will fail financially.What is discounted cash flow? This jargon term describes a very complicated and misguided way of valuing a business. It is especially misleading when assessing a small business.When people use discounted cash flow (DCF), they are saying that a stream of cash will have a certain value in time. The guesses – and I do mean guesses – that they use are: What the interest rate will be, the discount to put on a business based on its risk (the more dicey the odds, the more they mark its value down), the enterprise’s projected growth rate, and its expected cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization).This information then goes into a formula where a value of your company will emerge. I can only tell you one thing about this method of valuation, it’ll be wrong. The value will either be too high or too low.Why is it flawed when valuing a small business? There are many reasons that discounted cash flow isn’t going to work for your business. Here are just some of them:The growth rate that’s being used will be wrong.The cash flow that’s produced could very possibly be an anomaly.Nothing happens in a straight line with a business.Private businesses are just unpredictable.Your growth will be too low to get a reasonable valuation.When you look at this list, you’ll see something in common. The reasoning behind DCF depends on the predictability in your business. If your business is anything like all those I see, there is little to no predictability in almost all smaller private businesses.Some other problems:You’re not paying for what the business will do. Every time I bought a business with a purchase price based on what was going to happen, I got burned. When I decided to only pay for what the owner had produced, I started getting deals that actually paid off.I learned that you’re not paying for what will happen. You should only pay for what’s happened in the past. That’s what the seller of a business is selling.If your seller isn’t willing to value his business on that basis, it’s time for you to move onMost people won’t understand DCF. It took me a long time to understand how discounted cash flow works. Whether you’re a buyer or seller, if you don’t understand how someone is valuing your business, you could be in for a very rude awakening.I hate it when advisors of any stripe tell you that you just have to trust them. All this means is the advisors don’t understand a technique well enough to explain what they’re doing in terms you can easily understand.When your advisor can’t translate any strategy to plain English, you’re in trouble. If you don’t understand what’s used to value a business you’re interested in, you either need to stay with it till you understand or just move on.If you’re holding debt, you really want a deal that works. I also often see buyers wildly overvalue a business using DCF. Most of the time, those buyers have formal training in a business schoolIf you see that your business is overvalued and you’re going to play banker for a significant portion of the sale, you should be very careful. When a business is overvalued, it’s only a matter of time before your payments slow or even stop.A good question to ask yourself is: If you were going to buy a business you were selling, would you pay the price you’re asking? If the answer is no and you’re holding paper, you should expect problems down the roadIf you’re selling to a private equity group, beware. Many times private equity firms use DCF to value your business – and use your last year or two as a guideline for what’s going to happen in the future. If you’ve been fortunate and your company has grown at a 20% clip, you could receive a very nice offer for your business.If you accept the offer, be aware that two unfortunate things that might happen. The first is you’ll be replaced as CEO if your growth doesn’t continue. A 20% annual growth year after year is a very difficult thing to do.And second: Look out if you took part of the purchase price in stock, or lent money to the acquirer to finance the deal. Should your company not perform the way your private equity groups think it should, there’s a good chance they’ll just stop paying you or make the value of your stock useless. Then you’re either going to accept the change or start a legal action.The best advice when selling or buying a business: Keep it simple and you’ll be happier.It’s just easier to use historical numbers to figure out what you’re going to pay for a business. Keep your valuation process simple and one that you understand. In the end you’ll buy or sell at a fair price.Follow AdviceIQ on Twitter at @adviceiq.Josh Patrick is a founding principal of Stage 2 Planning Partners in South Burlington, Vt. He contributes to the NY Times You’re the Boss blog and works with owners of privately held businesses helping them create business and personal value. You can learn more about his Objective Review process at his website.AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.