Whether you’re buying, selling or exiting a business, accurate business valuation skills are incredibly important to have.
In essence, business valuation determines its current worth by using objective measures and evaluating all aspects of the business.
The ultimate ‘value’ of a business is determined by several factors, including profitability, assets and the potential risks and threats that face the business.
A business valuation can be done in several different ways; often using a combination of the methods that we’ll discuss. In this article, we’ll break down what these methods are and help you improve your ability to establish a business’ value successfully.
Why would I need to value my business?
The following are common scenarios where you might need to value a business:
Buying or selling a business: During negotiations for the purchase of a business, both parties will often have differing opinions on the business’s worth. Being able to determine the value of a business and communicate your valuation effectively will be a powerful negotiating tool and will help you avoid overpaying/underselling the business.
Capital financing: When reaching out to lenders and potential investors for funding, presenting precise financial data is critical. These parties want to know where their money is going and want assurance of your business’s health and profitability. Providing lenders and investors with an effective valuation of the business will strengthen your case and significantly improve your chances of getting necessary funding.
Personal reasons: There are many other scenarios where determining your business's value would be beneficial. These can range from if you’re planning to retire or exit the business, adjusting your business strategy, or engaging in legal proceedings (such as a divorce settlement).
What are the different methods to value a business?
Asset-based valuation is the most straightforward method of valuing a business. It essentially involves adding up all of the business’s assets (e.g., cash, equipment and stock) and subtracting all of its liabilities (e.g., bank debts and other outstanding payments). A buyer may also decide to purchase the assets only rather than take over the business and its outstanding debts.
Due to the simplicity of this method, asset valuation leaves out intangible factors such as ‘goodwill’ that may be relevant to a business’ value. Because of this, the asset valuation method is considered more appropriate for asset-rich companies with relatively little goodwill attached.
The earnings multiple method is one of the most common ways to value a business.
The method involves determining a business’s EBITDA (earnings before interest, tax, depreciation and amortisation) and multiplying it to give it a value.
An industry standard may determine the value of this ‘multiple’. Certain industries have a standard EBITDA multiple range that is used to calculate the typical returns and risks associated with that type of business.
For industries where a standard EBITDA multiple is not commonly used, a number of other factors are also used to determine this value. These include:
- Dependency on owner/operator
- Access to capital
- Business/product diversification
- Economic and industry outlook
- Historical profits
- Market size/position
- Competition pressures
For example, a business in the professional service industry may have an EBITDA multiple of 4. If the business’ earnings before interest tax, depreciation and amortisation is $100,000, this would be multiplied by 4 to reach $400,000. This figure would be the value of that business under earnings multiple.
Inevitably, there is going to be some guesswork involved in these calculations. The earnings multiple method is simply used to reach an acceptable figure based on the business’s performance and other comparable sales in the industry.
Capitalised future earnings
If a healthy business generates a profit and consistent revenue, capitalised future earnings can be an effective method to value it. The capitalised future earnings method is used to compare different businesses to find the best return on investment (ROI) by utilising factors like current earnings, cash flow and the annual rate of return.
The value is achieved by:
- Calculating the average net profit of the business over the previous few years. Make sure you consider the market conditions that lead to these outcomes and if any factors could impact these figures in the future.
- Dividing the business’ expected profit by its costs to determine the ROI as a percentage. For example, a $100,000 profit with $60,000 in costs results in an ROI of 40%.
- Returning the ROI to a decimal and dividing it from the net profit. In this scenario, it would be done like so: $100,000/0.4=250,000.
As a buyer, you can get a practical idea of the market price for a business by looking at the sale price of other businesses. This involves looking at the recent sales of businesses that are of similar size and operate in a comparable location or industry.
To find this information, you can search business sales listings in industry newspapers and websites or speak to a business broker who can use their experience to give you a general indication.
What about goodwill?
Goodwill is essentially the difference between the net sum of a business' assets and its true worth. This refers to the reputation that has been built, with loyal customers, a strong brand and happy employees all constituting the ‘goodwill' that a business has accrued.
Whilst goodwill is intangible, it can be a crucial factor to consider when seeking on the true value of a business.
If you need further help with a business valuation, we recommend seeking an expert opinion.
For more accounting help and business advice, get in touch with Elephant Advisory’s accounting team.