Opportunity cost is key to value of a firm

I often have the opportunity to visit with business people who are trying to determine the value of their business for one reason or another. Sometimes they are pleasantly surprised at the determined value; other times the surprise is quite unpleasant.

By Hal Heaton
Brigham Young University

I once spoke with a woman about her retail business. Because she was renting a location at an outdoor mall, the business had no real assets except for inventory. When I asked about how much money the business made, she indicated that it had profits of between $30,000 and $40,000 per year. At first it sounded like the business might be worth a quarter to a half million dollars.

But then I asked to see the financial statements. I was surprised that wages were so low. The woman indicated that she had a couple of people who worked part-time whom she paid directly, but that she spent six days a week there and often was there more than 10 hours a day. She took her salary out of the profits.

I was incredulous. "You mean that you spend 50 to 60 hours a week working," I asked, "and your only compensation is the $30,000 to $40,000 in profits?"

When she responded affirmatively, I had to reluctantly inform her that her business was worthless. There was no way she could hire someone at her skill level who would be willing to put in that many hours for that much money. I explained that the business is only worth the present value of the cash flows after all costs. She had not subtracted the value — the "opportunity cost" — of her time. In fact, I am sure that someone with her ability and experience could easily command a salary of more than $50,000 if she worked for someone else — and she would not have to work six days a week.

Unfortunately, she didn’t understand the economic concept of "opportunity cost." It is the foundation of all wealth-building decisions for successful entrepreneurs. Although it can be confusing, the simple explanation is that the opportunity cost is the next best alternative. Entrepreneurs need to understand the concept — and learn how to make it work for them.

On one occasion I was trying to value a business and noticed that the income statement indicated virtually no profits for several years. I was nervous that the business would be worthless even though the owners had expressed that it must be worth several million dollars based on some similar businesses that had sold recently. Upon closer examination, however, I learned that the two owners were paying themselves over a million dollars a year each in salaries. I estimated that they could hire skilled managers to take their places for about $100,000 per year; therefore, the true — or economic opportunity — profits of the business were a couple of million dollars a year. The business was indeed worth several million dollars, but you would not be able to tell that from the financial statements.

The concept of "opportunity cost" was critical to the value of the business. Whenever you make a business decision, you must always look at the next best alternative. For the woman, her opportunity cost was probably a salary of $50,000 per year with a lot less hours. When you compare this to the $30,000 to $40,000 she was making in the business, the business was worthless. For the partners in the second business I valued, the opportunity cost would be earning $100,000 or so elsewhere, adding substantial value to the business even though the financial statements didn’t show it.

Many entrepreneurs are surprised to learn that true value and the best business decisions are determined by the opportunity cost, and not necessarily by actual dollars.

Whether that surprise is pleasant or not.

Hal Heaton is associated with the BYU Center for Entrepreneurship. He can be reached via e-mail at [email protected].

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