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How To Use Business Value
As The Ultimate Performance Indicator
By David E. Coffman CPA/ABV, CVA
Business performance measurement and management
promote the use of carefully selected key performance indicators to
evaluate the performance of a company, its management and employees.
Management theory has long recognized that the primary purpose of a
company’s management is to maximize shareholder value. For large
companies with stock that freely trades in public securities markets,
this is a simple process of monitoring stock price. For small, private
companies the situation is quite different.
Large, public companies have many stockholders that
elect a board of directors, who in turn hire the key executives. This
separation of ownership from management does not exist in small, private
businesses. Often these three groups (owners, directors and management)
are comprised of the exact same individuals. Small businesses become
extensions of their owners in many ways including their objectives.
Owners are typically more concerned about objectives like: minimizing
taxes, maximizing personal income, maintaining personal lifestyles,
minimizing the assets held within the business, and protecting personal
assets. Pursuit of these objectives tends to minimize the value of small
businesses. Owners often are not very interested in the value of their
businesses until something happens that makes it important like a
divorce or wanting to retire.
Do small business owners really not care about
business value? Or is it because they are not accustomed to having it
available? Business valuations cost thousands of dollars, so small
businesses can’t afford to get one on a regular basis. If it is not
practical to measure something, it becomes unimportant. If the value of
small businesses were readily available, like public companies, then the
owners would become interested in it. Quite possibly they might shift
their business objectives to maximize value.
Those who have tried to monitor business value
without paying for regular business valuations often used industry “rule
of thumb” formulas. While formulas are easy to use they have some
serious drawbacks. They are based on data of unknown quality and
quantity. The formulas are expressed in ranges that produce widely
varying values. They do not take into consideration the unique facts and
circumstances of each specific business.
There is a better solution. Much more information
is now available about the sales of small, private businesses. There are
a number of sources that have collected data on thousands of
transactions over many years. These databases provide actual market
data. Professionals and commonsense suggest that quality market data is
the best source for appraising any property. The databases have some
shortcomings, too. The information is limited to basic data like annual
sales, asking price, cash flow, selling price, etc. And some types of
businesses don’t have many transactions. The databases work best when
there are many similar transactions, so common businesses like
restaurants are good candidates. Averaged figures from many transactions
offset any extreme or unusual cases. The ratio of selling price to
annual sales, or selling price to cash flow is typically used to
calculate a specific business’s value.
These databases are available by subscriptions that
are not cheap. So it is not practical for a small business owner to
access them directly. And the professionals who do subscribe aren’t
prone to sharing them. There are a few companies that for a small fee
will search the databases for transactions involving similar businesses,
calculate the average ratios, and use them to calculate the value of a
small business. These low cost business valuations based on actual
market data are great tools for making business value readily available
for most small businesses. Using this tool, small businesses can finally
start using business value as the ultimate performance indicator, just
like public companies.
© 2005 David E.
Coffman
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