As carnival season comes to an end, it seems like an appropriate time to get back to the basics and remember how we got here. Early in his career, our founder, Chris Mercer, considered six underlying financial, economic, logical, and psychological principles that provide a solid basis for considering valuation questions and issues. Each principle provides a way of looking at the world from a valuation perspective, and integrating the perspectives provides a logical framework to examine elements within business valuation.

As a family business director, many decisions you’ll make in 2025 will require assessing the value of the company’s shares, a particular business segment, or a potential acquisition target. What should you and your fellow directors know about valuation? In our experience, getting back to the basics with these six principles can be worthwhile.

1 – The Principle of Expectations

A simple but overlooked aspect of valuation: today’s value is a function of tomorrow’s expected cash flows, not yesterday’s performance. Historical analysis is important to develop reasonable expectations for the future of a business, but investors pay for what will happen in the future. The principle of expectations reminds us to remain oriented to the future.

2 – The Principle of Growth

Because business valuation is based on expectations for the future, it stands to reason that growth is a key factor in measuring the value of a business. How will your business grow? To answer this question, it is often helpful to take a step back and situate your family business in the context of expected growth in the overall economy, industry, and local economy.

Investors look at the world, the economy, and individual businesses with an underlying assumption that growth will occur.

3 – The Principle of Risk & Reward

Return follows risk. This principle suggests that an investor considering two potential investments, with one clearly riskier than the other, will require a greater expected return for the riskier investment.

You can think of risk in terms of the variability in future outcomes. The future returns for an asset are always unknown, but some are more uncertain than others. Directors need to think about the future not just in terms of a single base case but also with reference to the range or dispersion of potential outcomes.

4 – The Present Value Principle

The Present Value Principle enables us to compare investments of differing durations, growth expectations, cash flows, and risks. Present value calculations allow us to express the present value of different investments in terms of dollars today and, therefore, provide a means to make investment or valuation decisions.

This principle describes the “time value” of money. In short, a dollar today is worth more than a dollar tomorrow. Since valuations are expressed in dollars today, directors need to consider the corrosive effect of time on dollars to be received in the future.  The present value principle is closely related to the principle of risk and reward since the riskiness of an investment determines how expected future dollars convert to present value.  The greater the risk, the lower the present value of a given amount of future cash flow.

5 – The Principle of Alternative Investments

As the supply of potential investments naturally exceeds the resources of any single investor, every investment is ultimately made to the exclusion of some other investment that could have been made. Frequently described as opportunity cost, when resources are deployed to acquire one asset, they are not available to purchase another.

Valuations are not made in a vacuum but are assessed relative to the risks associated with, and returns available on, alternative investments in the market.  The principle of alternative investments confirms that any valuation conclusion is specific to a particular date.  The value of any business changes over time in response to continual changes in the value of alternative investments.

6 – The Principle of Rationality

Value depends on the Principle of Rationality. Despite the occasional counter-example, markets are eventually rational. Even for small family-owned businesses, there are enough market participants to generally keep everyone honest.

What are the strategic advantages that your family business possesses? To grow a sustainable family business, you need to be focused on the strategic advantage that makes a difference in a rational market. There is an underlying rationality to market transactions, even when that rationality may not be immediately obvious.

Final Thoughts

In our experience, keeping these six principles in view is essential for directors as they deliberate, assess, critique, and develop valuation estimates. If you have a specific valuation challenge that you and your fellow directors would like a second opinion on, give one of our valuation professionals a call to discuss your situation in confidence.