If you are, it is very important to understand how to value a business correctly. This article introduces three basic but important principles of business valuations to help you get started.
The Principle of Alternatives
The Principle of Alternatives states that each party always has an alternative to consummating a transaction. This seems like a no brainer but this is one of the fundamental principles of business valuation.
This principle is profound in many ways. For example, as you negotiate to buy another business, never get into the mentality that you just have to buy that business. Many companies and individuals grossly overpay as they get tunnel vision.
The Principle of Substitution
The Principle of Substitution tells us that the value of something tend to be the price paid for an equally desirable substitution. As a profit maximizing agents, we all try to minimize cost, all else equal. The value of a business, therefore, is the smallest price paid for substituting the business with something equally desirable.
Example 1: If a business could be replicated for X amount of dollars (by purchasing and operating the exact assets that a business has), then the Principle of Substitution tells us that it is the business is worth at most X amount of dollars.
Example 2: In this example, you want to determine the value of business A. Business A costs $5 million to replicate exactly. However, another equally desirable but different business could be acquired for only $2 million. The Principle of Substitution tells us that business A is worth at most $2 million dollars.
The Principle of Future Benefits
Unless you are buying a company only to liquidate instantly, you care a lot about the future benefits of owning that business. The Principle of Future Benefits tells us the economic value of a business reflects (anticipated) future benefits.
Although you shouldn't buy a business solely based on the past, the past could sometimes be an indicator of what is to come. The Principle of Future Benefits is why a fast growing company sells for much more than a slow growing one. The principle also explains why an industry might experience a surge in business valuations when a favorable has been passed.