Business valuation

Putting a price on a business is challenging. In this issue, we discuss a few basics to give you guidelines for estimating its value. Note that a prospective buyer of your business might use similar principles to estimate its value. Also, note that there is no single formula for valuing a business. Rather, a few different models can be used for business valuation based on the nature and the size of the businesses and concerned risk factors.

Reasons for valuing a business

• There are many reasons for the valuation of a business –
• The business is up for sale.
• You’re trying to find investors.
• You plan to sell stock in your company.
• A bank loan is required against the business.
• Changes in ownership/capital structure.
• Company divestments/acquisitions.

Factors to consider when valuing a business for a sale

If you’ve decided it is time to sell your small business, there are several factors you will have to consider first.

Lease – If your business rents premises, you will need to liaise with your landlord to discuss the state of your lease. You may ‌transfer it to the new owner, or if it is due to expire, they may need to be granted a new lease. If you own your premises, you will need to consider whether to sell it to the new owner or have them lease it from you.

Licences – The licences for certain businesses, like restaurants and cafes, are usually included in its sale. You will need to gather all the documentation for your current licences to include in your sale contract.

Stock—Will you be including your remaining stock in the sale of your business? If so, you will need to value it and factor that into the contract.

Tax Implications—Selling a business can lead to complex taxation issues. These include calculating GST for the sale price of the business and considering Capital Gains Tax implications. These matters are best discussed with an accountant who can guide you through the process.

Contracts & Suppliers—Your business may have ongoing contracts with suppliers and customers. These may be short-term orders to fulfil or long-term service contracts. You will need to decide whether to transfer these contracts to the new owner or terminate them. Be sure to check with your lawyer regarding the contracts’ specific details, including termination clauses.

Business History—Important information that will affect your business’s value includes its duration of operation, how it started, its reputation, the condition of its facilities and whether or not its goal has remained the same.

Employees – Employee pay rates, morale, job descriptions, and whether or not technical/ specialist skills are required to operate the business. A critical piece of information here is whether or not the business relies on a few people, as this shows which skill sets will serve as the foundation of operation.

Legal & Commercial Issues – Nobody wants to purchase a business with pending legal or commercial problems. Involvement in pending legal proceedings, compliance with work, health, safety, and environmental laws, long-term commercial contracts (including their period of validity and value), and whether or not the business has the necessary permits, registrations, and licences will greatly affect value.

Goodwill & Intangible Assets—Does the business include certain intellectual properties, other intangible assets, or goodwill? Depending on the industry, the value of intangible assets can play a major part in determining the business’s market value.

Financial information—Financial Information includes profitability, working capital, sufficient cash flow, the amount of debt that the cash flow can service, recent annual turnover, whether profit is increasing or decreasing, and the value of key tangible assets. It is also important whether there is enough working capital to pay shareholders’ dividends.

Types of valuation methods

An obvious starting point for valuation is the business’s profitability, balanced by the risks involved. Other valuation methods are asset valuation, price-earnings ratio, and entry cost valuation. There are also industry rules of thumb that you can consider for business valuation.

Capitalised future earnings method:

Capitalised future earnings are the most common method for valuing small businesses. When you buy a business, you’re buying its assets and the right to all future profits it might generate, known as future earnings. The future earnings are capitalised or given an expected value. The capitalisation rate can be an expected return on investment (ROI), shown as a percentage or ratio. A higher ROI is a better result for the buyer. This method lets the buyer compare different businesses to determine which would give them the best ROI.

To calculate value based on the capitalised future earnings method, first, calculate the business’s average net profit for the past three years, considering whether any conditions might make this figure difficult to repeat. Then, divide the business’s average profit by using an expected ROI considering the sector and the business.

For example, if the expected ROI is at least 50% and the average profit is $100,000, the value of the business can be calculated using the formula below.

Value or selling price = (100,000/50) x 100 = $200,000.

Multiples of revenue method:

The multiples of revenue method is a simple valuation method for finding a business’s maximum value. Annual revenue can be considered for a set period of time, and then a multiplier can be used to determine value. The multiple varies by industry and other factors; however, it usually varies from less than one to three or four.

Small business valuation often involves finding the lowest price someone would pay for the business, known as the “floor.” This is often the liquidation value of the business’s assets. Then, a ceiling is set. This is the maximum amount that a buyer might pay, such as a multiple of current revenues. However, the growth potential of a specific business can impact the multiplier. For example, the multiplier might be higher if the company or industry is poised for growth and expansion. A high percentage of recurring revenue and good margins can also boost the multiplier. The multiplier might be one if the business is slow-growing or doesn’t show much growth potential. Economic and industrial conditions can also impact the multiplier.

Earnings multiple method:

The earnings multiple method is similar to multiples of revenue. This valuation method can be used to value larger businesses. The earnings before interest and tax (EBIT) are multiplied to give a number, the multiplier. The multiplier can be found by dividing the stock price by earnings per share (EPS) to find the P/E ratio.

The simplicity of multiples makes it easy for most to use. However, this simplicity can also be considered a disadvantage because it simplifies complex information into a single value.

Asset valuation method:

This method adds assets such as cash, stock, plant, equipment and receivables. Liabilities, like bank debts and payments due, are deducted from this amount, leaving the net asset value. For example, Raymond wants to buy a manufacturing business. It has $300,000 worth of assets and $200,000 of liabilities. With the asset valuation method, its net asset value is $100,000, so this business is worth $100,000.

The asset valuation method may consider the business’s goodwill on top of the net asset value. Goodwill represents features of a business that aren’t easily valued, such as location, reputation and business history. It’s not always transferred when you buy a business since it can come from personal factors like the owner’s reputation or customer relationships. The asset valuation method may not consider goodwill if the business is underperforming.

Discount cash flow method:

The discount cash flow (DCF) valuation method does not consider other companies’ results. Instead, it focuses on your company’s projected cash flow. You’ll give your best cash flow forecast for three to five years. Then, using a formula, you will calculate the present value of those cash flows.

Present value is a concept that compares the business’s current value in terms of future cash flows to how much the purchaser would pay now. This method uses a discount rate, which is the likely interest rate the business purchaser could have gotten from saving the money in a bank account. If your company’s present value exceeds the investment amount, it’s a good investment for the business purchaser.

The projection of cash flow sometimes requires assumptions of future business conditions. Hence, it can be complex and prone to error. This valuation method can be used in conjunction with the other methods.