What is Your Business Worth
There are several reasons that may lead to a business being valued. The most common is when buying or selling a business. Other reasons can include partnership splits, succession and estate planning, reorganisation, settlements, insurance, death/incapacitation of business owners, matrimonial splits, verification of net worth for investors or banks, as well as just wanting to know what your business is worth.
Determining a fair market value will be influenced by the type of business and the reason for the valuation. A key component will be the ability of the business to generate consistent profits, which will require an analysis of past and current earnings, as well as the sustainability of those earnings. Unfortunately, merely looking at last year's financial statement and making an estimate is often incorrect and misleading. A realistic business valuation requires a thorough analysis of several years of the business operation and an opinion about the future outlook of the industry, the economy and how the subject business will compete.
Valuing a business is complex and needs professional, experienced analysis. Business owners thinking of selling should also be considering succession planning and they should have an exit strategy in case of sudden health issues, change of family circumstances, or retirement. They should be planning years ahead if they wish to get the maximum value when selling their business by using a business exit strategy programme. A valuation is only as good as the information provided about the business, so it is important that the information is accurate and complete.
The main approaches to valuing a business include:
- Asset based
- Income based
- Market based
Asset valuation is usually used when a company is asset-intensive, such as retail and manufacturing businesses. This approach takes into account the following figures, the sum of which determines the market value:
- Fair market value of fixed assets and equipment. This is the price you would pay on the open market to purchase the assets or equipment
- Leasehold improvements. These are the changes to the physical property that would be considered part of the property if you were to sell it or not renew a lease
- Owner benefit. This is the seller's discretionary cash for one year
- Inventory. This is the cost price of inventory, including raw materials, work-in-progress, and finished goods or products
Asset-based business valuations can be done on a going concern or on a liquidation basis.
- A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities
- A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off
The challenge is to find comparable market values for all assets and how to measure intangibles such as intellectual property, owner experience and proprietary licenses on patents. These are assets that are typically not recorded on company balance sheets.
As a result, asset based valuations are not usually an accurate estimate of business value.
This approach places no value on fixed assets such as equipment, and takes into account a greater number of intangibles and is based on the idea that a business's true value is in its ability to produce wealth in the future. A common earning value approach is Capitalising Past Earnings.
This valuation method is best used for non-asset intensive businesses like service companies.
With this approach, the company’s past record of earnings is used to determine an expected level of cash flow that is then adjusted for unusual revenue or expenses, and is multiplied by a capitalisation factor. The capitalisation factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
Discounted Future Earnings is another income approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalisation factor. This approach is based on the principle that the value of the business is equal to its future cash flows discounted to net present values at a rate which reflects the risk in the business. It is more appropriate where there is little history, and so it relies on a 3-5 year forecast of earnings.
The challenge can be determining what the capitalisation rate should be. Factors that should be taken into account to determine the capitalisation rate include:
- The owner's reason for selling
- The length of time the company has been in business
- The length of time the current owner has owned the business
- Degree of risk
- Growth history
- Entry barriers
- Customer base
- Future potential for the industry
As a guide, well established businesses with a history of strong earnings and good market share might trade with a capitalisation rate of 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalisation rates, around 25% to 50%.
Market Value Approaches
This approach finds the value of a business by using an "industry average" sales figure as a multiplier. This industry average number is based on what comparable businesses have sold for recently. As a result, an industry-specific formula is developed, usually based on a multiple of gross sales. However, this approach doesn’t take into account how different two businesses in the same industry can be, and only has some relevance if there are a sufficient number of similar businesses to compare.
What is Valued in a Business?
- Goodwill - This is the subjective and intangible stuff that can be difficult to value and is often determined by what the market is prepared to pay
- Stock - SAV means stock at valuation [cost], but obsolete stock will be valued below this
- Plant - This is usually priced as a going concern with its value determined by a registered valuer. These are the tangible things required to run a business
The true value of a business at the end of the day is what someone is prepared to pay for it. It’s important to be realistic and to get a professional business valuation in the first place. Businesses are as unique and complex as the people who run them and are not capable of being valued by a simplistic rule of thumb. The important factor in any valuation is that the method used is relevant to your type of business, providing a valid and supportable value.
So once you have made a decision to get your business valued, choose a professional who will provide a clear explanation of their valuation method, as you need to understand the possible valuation methods to be able to clearly defend the price of your business. For a buyer or investor, the reasoning behind the pricing is critical for evaluating the personal risk involved.