FEBRUARY 8, 2007
Introductory notes on the Dragons Den
There are always certain things that strike me as lacking realism about the Dragon’s Den. The first is that the format creates an unnatural reversal of the laws of supply and demand. In the Den, apples fall up.
What I am talking about with this poorly placed metaphor is, in fact, the key and endlessly fascinating subject of business valuation, and how you do it.
In this matter, there are two opposing schools of thought held by the ‘Textbooks’ and the ‘Bulls’. The Textbooks believe valuation is principally derivable as a matter of formula driven fact. Thus, a business is worth ten times its earnings, or five times the value of its sales. This is often the most commonly used valuation and is called the multiplier method.
The other most common Textbook approach is using discounted cash-flow method. It’s probably worth stopping here a minute, leaving our Bulls stamping in their field, to look at the difference between these.
The discounted cash-flow method determines the current value of a company using future cash flows adjusted for time value. This is the method most commonly used for valuing a company with anticipated high growth. Its focus is the opportunity value of the business going forward, and does not give any regard to the current sales or profits the business. It is for this reason that the Dragons never value this way, much easier to use the current performance of a nascent business and thus achieve a far lower valuation.
Lets use Igloo, the specialist refrigerated delivery service from last Wednesday’s programme, as an example. In the current year of trading, profits are £18,000. Small businesses usually sell at a multiple of profits of between 1 and 5. This method would give Igloo a valuation of at maximum £90,000. Given that the sales from the business are already over £200,000, this seems a gross undervaluation, and indeed it is. The bottom line profits figure to which we have had to apply this to do not exclude exceptional items associated with growth. We might guess at the before exceptional item profit of £80,000. This would value the business at £400,000. But hang on, the Dragon’s paid £160,000 for 22.5%, giving the business an overall valuation of just over £711,000. So are Igloo so ‘cool’ as to have beaten the Dragons?
If we look at the same business from a discounted cash-flow basis the picture is quite different. Igloo forecast profits of £300,000 in three years time. At a future multiple of 5 this would value the business at £1.5 million. Now, say the Dragons want to see their money grow by fours times over this four year period, for every £10,000 put in they would require £40,000 out. If the Dragons own 22.5% of the company, then at the end of three years, their stakes would be worth £337,500. This means that to quadruple their money they would need to invest no more than £84,375 for their stake. As it is, with an investment of £160,000 they will only double their money in three years, not a good return for an Angel.
But hang on a minute! We’ve forgotten those Bulls. How would they value Igloo?
Well, Bulls are always on the seller’s side. A Bull is all about maximising the value of the business by stimulating interest from multiple parties, thus creating a sellers market, seeking buyers that would perceive a strategic advantage in partnering with the business, or a threat by not doing so.
For a Bull, value is the eye of the beholder. Perceived value to potential buyers is everything?
As a Bull friend of mine says, valuation is all about whose got the biggest balls.
So, if you stamp enough you can drum up any value for your business, regardless of reality? Well not quite. It takes having very high growth potential, a big vision, management credibility, and the right coach to market and negotiate your deal. Actually not easy – so maybe stick to discounted cash-flow method after all?
What I am not going to tell you yet is why the Den normally defies valuation gravity, for that you’ll have to wait for next week’s instalment.
What I am going to say however is if you want to make a lot of money with your investments, buy like Dragon but sell like a Bull.
If you don’t well, you can always try selling Igloos to the Eskimos.
On a final note, I would have actually stumped up my cash for some Reggae Raggae sauce. Sing-on Levi Roots!
-White Knight
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