Every accountant, attorney, or advisor guiding a privately held business owner eventually runs into the same question: “What is the business really worth?” The word “really” suggests a bit of skepticism and proposes the need for a framework. This series dissects that structure; the anatomy of a valuation that the opposing side of the table will respect rather than tear apart. Part 1 covers the numbers themselves; the methods, the adjustments, and the two inputs that quietly control the entire conclusion.
If there is one word a business valuator should live by, it is “defensible.” You can never do too much when backing your valuation with the right data, documented assumptions, and thorough due diligence. But you can do too little. Every accountant, attorney, or advisor guiding a privately held business owner eventually runs into the same question: what is the business really worth? The word “really” suggests a bit of skepticism and proposes the need for a framework. But the framework is usually wrong. Business owners provide an EBITDA multiple they heard at a trade conference or a cocktail party. It is Hollywood-esque. It is empowering. And it is cool to speak in those terms. It is also how respect gets lost. These multiples do not survive an analyst’s review.
I have watched numbers live and die in negotiations. The difference between the survivors and the casualties is rarely intelligence or data. It is the structure, the framework. This series dissects that structure; the anatomy of a valuation that the opposing side of the table will respect rather than tear apart. Part I covers the numbers themselves; the methods, the adjustments, and the two inputs that quietly control the entire conclusion. Part II asks a question most people skip entirely: what, exactly, is being sold? Part III walks through the risk factors inside the business that inflate or deflate value (and what to do about them once the number is on the table).
Strength in Numbers
Business valuation is considered both art and science. There is black and white. And there is gray. The methodology is the part of the valuation process that is black or white. Either you ran the three valuation approaches or you did not. Either you normalized the earnings or you did not. Either your discount rate has a documented build-up or it does not. Either your terminal value assumptions are internally consistent or they are not.
The assumptions, on the other hand, are where the gray comes to life; growth rates, margin trajectories, how long the customer contracts will really last. Valuation professionals can disagree about assumptions, and it is expected. But here is the key insight that separates a defensible valuation from a vulnerable one: you earn the right to argue about the gray by getting the black and white unimpeachably correct. Join me to explore the black and white.
Triangulation: Three Approaches, One Conclusion
Valuation professionals work from three methods, and a defensible report considers all three; even when it ultimately relies on one.
The income approach focuses on the earning capacity of a business. The gold standard is the discounted cash flow (DCF) methodology, values the business as the present value of its future cash flow. This is the intellectually purest approach; a business is worth what it puts in its owner’s pocket, adjusted for risk and timing.
The market approach values the business by comparison: what have similar companies sold for, either in private transactions or as public companies? If four comparable HVAC contractors sold for 4.5 to 5.5 times EBITDA last year, that range is evidence of how much the market is paying.
The asset approach values the business as the sum of its parts; assets minus liabilities, adjusted to fair market value. For operating companies with healthy earnings, this typically sets a floor, but for holding companies, asset-heavy businesses, or distressed situations, it can be the headline act.
Why use all three when one would do? For the same reason experienced pilots still go through their checklist; a mistake is unaffordable. It also sends a message to the negotiation table: you did your homework.
Normalization Adjustments: Finding the Real Earnings
The owner’s goal in most instances is to minimize taxable income. So, before any method can be applied, the financial statements must be normalized, which means to restate earning capacity to show what the business would earn if some corrections would be made.[1] Here are the ones that show up in nearly every engagement and what to do about them:
Owner compensation—Founders rarely pay themselves what the job is worth. Some pay themselves generously above market because the business can afford it; others take almost nothing because their accountant prefers distributions to optimize taxes. Either way, compensation needs to be adjusted to market rates, and the salary survey behind that adjustment needs to be documented.
Personal expenses running through the business—The fishing boat used as a “client entertainment” expense, the country club fees presented as “networking fees”, the three family cell phone plans; each item has to be added back if the business runs without them. They must be identified and quantified to correct earnings and balance sheets.
One-time and non-recurring items—The one-time events like a lawsuit settlement, the COVID-era grant, the gain on selling old equipment; earnings should reflect non-extraordinary income and expenses. Extraordinary items should be eliminated.
Related-party transactions—The company rents its building from an LLC the owner also controls. Rent is set by the owner at $8k a month when comparable market rent is $14k. Every related-party arrangement gets restated to market values.
Non-operating assets—The $900k of excess cash and the vacation home in Miami showing in the company’s balance sheet are valued separately from the valuation and added to (or carved out of) the operating value.
Here is the discipline that makes normalization defensible: every adjustment gets a source document, a rationale, and a consistent direction of logic. Otherwise, the valuation report is an exhibit that can (and will) be used against you. If there is one thing I can conclude, keen reader, after doing this for 20 years, is this: doing the homework pays off.
The Discount Rate: Where Small Numbers Do Heavy Lifting
If normalization determines what you are discounting, the discount rate determines how hard. And no single input affects the valuation as much as the discount rate. So, what is the discount rate? It is the return a reasonable investor would require to buy a company (and with it, its stream of cash flows), given its risk.
But wait, how do we determine what a reasonable investor would expect? We look at the industry returns and make adjustments to make the discount rate applicable to this specific company. For private companies it is typically constructed through a build-up method. The elements of the discount rate are:
- Risk-free rate—The 10-year U.S. treasury note is considered the benchmark for this.
- Equity risk premium—This is the additional return an investor expects above a risk-free return when investing in equities.
- Size premium—A small company is considered riskier than a bigger company (the bigger one is assumed to be more diversified). This means that the expected return on a smaller company is also higher. The higher the risk, the higher the expected risk.
- Industry adjustment—Each industry has different risks, so the math has to be adjusted to reflect investing in one industry vs another (space exploration is considered riskier than running a franchise).
- Company-specific risk—The premium for everything unusual about this business.
To illustrate: assume the discount rate is calculated at 16%. On a business generating $1 million of steady annual cash flow, a 16% capitalization rate implies a value of $6.25 million. Move the rate to 18% and the value falls to $5.56 million. That is nearly $700,000 of value swung by two percentage points. This is why the discount rate build-up must read like a documented chain of custody. Each component ties to published data, except for company-specific risk which is pure professional judgment. Company-specific risk is the single most cross-examined number in valuation litigation. The best way to defend it is with specificity. (If company-specific risk factors sound like they deserve their own discussion; they do. That is Part III.)
Terminal Value: The Elephant in the Room
Here is the dirty little secret of every discounted cash flow: most of the value does not come from the forecast. It comes from the terminal value. A typical five-year DCF projects cash flows for years one through five and then collapses everything beyond year five into a single number: the terminal value. In practice, the terminal value single number routinely represents 66% to 75% of the total concluded value.
Read that again.
The majority of the valuation is parked at the end of the valuation horizon. Terminal value is usually estimated one of two ways:
- Using the Gordon growth model, which assumes the business grows at a constant rate forever, or
- An exit multiple, which assumes the business is sold at year five for some multiple of its earnings.
Both are legitimate. Both are intuitive. And both are misused.
The first “classic” misuse is setting a terminal growth rate that is bigger than GDP growth forever. Nonsense. A best practice parks terminal growth rate at or below long-run nominal GDP growth. The second misuse is internal inconsistency; a terminal value that assumes mature, steady-state growth right after year five, while the first five years are reflecting heavy investments. Do investments go away forever after year five? Nonsense. The third misuse is applying an exit multiple imported from booming comparable transactions applied to a conservatively forecast business. More nonsense.
A quick self-audit anyone can do:
- What percentage of total value sits in the terminal value?
- What is the implied terminal growth rate, and how does it compare to GDP?
- Would the exit multiple be believable if the buyer’s own banker proposed it?
If any of those answers make you reposition yourself in your chair, the number will not survive a room full of motivated skeptics. Remember: every question that cannot be properly addressed can mean hundreds of thousands, if not millions of dollars.
Strength in Numbers
Defensible numbers come from using the right framework; methods that triangulate, earnings that are normalized, discount rates that are assembled component by component, and a terminal value that respects arithmetic, economics, and -quite simply, common sense. Black and white where the profession demands it; gray only where judgment legitimately lives (and even then, we document). But a technically flawless calculation can still value the wrong thing. A 30% interest in a company is not simply 30% of the company’s value, and a share of a company you cannot sell is not worth the same as a share of a company you can sell fast. Defining precisely what is being sold (and profiling its risk accordingly) is where we go in Part II. See you there.
[1] In our firm, we call the team that performs the normalization adjustment the “department of corrections.” We like to think we have a sense of humor.
David Lopez, CVA, is the Principal of M1 Valuations, a valuation and M&A advisory firm. He is a former Deloitte and PwC management consultant, and was CFO for an aerospace company holding contracts with the Air Force, NASA, and the Pentagon. He holds an MBA from INCAE Business School (awarded a full scholarship) and is a two-time TEDx speaker. Mr. Lopez has signed 200+ valuations totaling approximately $5B in enterprise value, has coached hundreds of CEOs through valuations, exits, and successions, and has presented at McCombs School of Business, Cox School of Business, Capital Factory, Tech Summit Silicon Valley, and on The Jeff Crilley Show.
Mr. Lopez can be contacted at (310) 490-5510 or by e-mail to David.Lopez@M1Valuations.com.
