Many business owners are under the false impression that valuing a business is only important when it comes to selling it.
Valuation is crucial when it comes to selling, sure, but it can also be helpful to have a fair idea of its valuation throughout your business journey, for any number of reasons – the most common being:
- You are expanding and buying another business
- You are selling the business
- You are divorcing/separating
- You are insuring the busines
- You are applying for a loan
- You are looking to attract investors
- You want to know your net worth
Throughout the process of business valuation, there are plenty of pieces of information you’ll need to have on hand, so making sure everything is prepared and ready to go is of the upmost importance.
What you’ll need to value your business
The history of your business
Your business will have come a long way from its humble beginnings and there’s no doubt it will evolve in the years to come. Having a record of the business’ origins, goals and journey so far is crucial to understanding its value.
Separate from personal information, having a thorough record of your employees means that potential buyers are aware of the job descriptions involved as well as special skills, pay rates and even staff morale.
Be mindful of current employees’ leave entitlements and how this will be handled in the sale. It’s also important to identify key employees – if that person leaves, will they leave your business in limbo?
This kind of information can impact the valuation.
Legal and commercial information
Information regarding your commercial contracts, lease arrangements, licences, permits and registrations can impact the value too. You must provide proof that your business complies with all relevant environmental and health and safety laws and disclose any current or pending legal proceedings.
Get advice about any location exclusion clauses that may affect the business.
Profit margins, annual turnovers, asset market values and an assessment of tangible assets all come under the financial information umbrella. All this can help valuers know a little more about the liabilities of your business as well as where you are thriving.
Market information and industry conditions
Take an objective look at the industry and think about short-term and long-term outlooks and how the industry is growing or shrinking. Consider your competitors and the competitive edge you have in the market.
These factors can influence your business’ value. Spending time assessing this type of market information is important; it can also make you aware of the prices other businesses in your market are being advertised for.
Put simply, business valuation is a process and set of procedures used to determine what a business is worth.
While this sounds easy enough, getting a business valuation done right takes preparation and thought.
There are a few common methods for valuing a business.
The value of a business can be calculated through considering the pricing guidelines of the industry it belongs to.
Some quick examples of industry valuation: fast-food businesses can be historically valued based on 40% of annual revenue, while motels may be based on a set price of $20,000 per room.
Each industry is different, so research your industry, discover industry rules and formulas and arrive at a clear understanding of where your business lies within the system.
Statistics Canada has plenty of statistical data, grouped by industry, that gives you a good idea of what factors might play a part in your sector.
Comparable business-based evaluation
This is where you take a look at businesses similar to the business you are trying to value. By reviewing comparable businesses, you can assess what a given business is potentially worth.
Of course, this method is not always accurate because every business is different, with different customers, locations, equipment and tools.
Using this method to get a specific number will not be in your best interest, but if you’re looking for a ballpark figure, it could be a great place to start.
Basing your valuation on assets can give you a really good idea of the value of a business.
Take both tangible and intangible assets into consideration, as well as appreciation rates, and you will get a good understanding of how much a business is worth.
To use this method, add up the value of your assets and subtract any liabilities.
The figures in your accounts are a good starting point but remember that financial advisors are obliged to be prudent: they must use the minimum the assets could be sold for.
So be realistic in your assessment of the value of your assets.
Tangible assets can be things like tools, equipment and property, while intangible assets are things like goodwill, brand and intellectual property.
Asset liquidation-based valuation
This valuation method is based on how much money the business owner would receive if all tangible assets were sold on the open market immediately.
Useful for businesses on the verge of closing down for good, it is less effective for businesses that want to continue operating, since it doesn’t take intangible assets (such as goodwill, customers, branding etc) into account.
Entry/start up costs
This method involves gauging how much money it would take to build the business from scratch to reach its current size, status and revenues.
Consider the time and resources it took to train staff, purchase premises and equipment and establish branding and marketing, along with a host of other factors.
Calculating these costs is not always an accurate method of valuation since, once again, it doesn’t take intangible assets into account.
Discretionary income-based valuation
Conducting a valuation via this method takes the current owner’s discretionary income into account so that the future owner’s income can be estimated and the return on investment calculated.
This only covers current income and cannot accurately encapsulate the future growth of the business.
Price/earnings ratio valuation
This is a common method. The market value per share is divided by post-tax earnings per share to deliver a P/E ratio.
For example, if a business is trading at $33 per share and has earned $1.30 per share after tax, it will have a P/E ratio of 25.38.
Generally, the higher the ratio, the more investors expect the business to grow in the future.
This is not always the best method for smaller enterprises, but no matter the size of a business, a rough estimate of value can be obtained using the P/E method.
Discounted cash flow
Discounted cash flow (DCF) analysis uses the ‘time value of money’ concept.
All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs).
If the value arrived at through DCF analysis is higher than the current investment cost, the opportunity may be a good one.
The business value is based on the estimated cost that any equipment, inventory, receivables etc would fetch on the open market if sold immediately.
Take the example of a company that makes a profit of $10k annually that is forecast to remain steady for the next 10 years. If a potential buyer wants to achieve a 10% rate of return, it’s like putting the profit into an ‘imaginary’ term deposit.
Would the investor get a better return if he or she put the profit in a bank today for five years? And the profit received in five years’ time: how much is it worth today?
This is because $10k received in five years’ time is not worth the same as $10k received today — because if your buyer received that $10k today they could put it in a bank (assuming a 5% interest rate) and in five years’ time it would be worth $12,763.
Working backwards, the $10k received in five years' time is actually worth $7,835 today, whereas $10k received in 10 years' time is actually worth $6,139 today.
Adding all these figures together gives the buyer an idea of how much he or she should pay now to receive the returns from the business in the future.
Multiplier valuation by sales
Each industry has its own publications, business brokers and industry associations that can provide current multiples for your industry. The multiplier method then uses the business’ gross sales multiplied by the multiple to reach a valuation.
For example, if gross sales are at $60,000 and the multiple is 0.4, the result will be a $24,000 business valuation.
This method doesn’t always give you the whole picture, because there are plenty of other factors that can come into play to alter the result.
Multiplier valuation by profits
This method gets its multiple from the profits of a business. Because of this, smaller businesses will slot into the lower range of multiples while bigger companies will fall into a higher range.
It can seem more clear-cut, because multiples are based on profits, but it isn’t always accurate, since it doesn’t take current financial status into account, nor can it account for any threats on the horizon.
No matter the method you choose, this article shows how business valuations are complex and detail-oriented.
It’s worth seeking specialist advice to ensure that you are buying or selling a business for what it’s worth.
What is business goodwill?
There are plenty of things about your business that can’t be tangibly measured, but these will still play a part in its valuation. These intangible sources are known as business goodwill and can include:
- Customer loyalty
- Brand recognition
- Staff performance
- Customer lists
- Management stability
- Intellectual property ownership
- Business operation procedures
Prospective buyers should also know the value of your business, so that they understand exactly what they’re getting when they hand over their money.
Of course, buyers and sellers can have very different ideas of what a business is worth – especially when the sellers have an emotional attachment to the business.
This is why it’s a smart move to bring in a business broker or professional valuer to assess your business without bias.
Once you’re confident in the value of your business, it’s time to start thinking about how to write the perfect advertisement to attract buyers. Once you’ve found a buyer then you’re advised to prepare for due diligence: the buyer’s thorough examination of accounts, customer/supplier relationships and physical assets.