Whether your client is selling their business or planning for the future, business valuation is a crucial skill for professionals in finance and accounting. In this article, we’ll break down the key concepts of business valuation in a clear and concise way. We’ll explore different valuation methods used by professionals, from calculating the value of your assets to analysing your earning potential and comparing your business to similar ones in the market.
By the end of this article, you’ll be equipped to:
- Grasp the scenarios where business valuations are necessary
- Understand the different valuation methods and their strengths and limitations
- Apply these methods to estimate the value of real-life business (with a sample valuation example)
What is a business valuation?
A business valuation is the process of determining a business’s economic value. It’s essentially figuring out how much a business is worth, like appraising a house, but for a company. This value considers all aspects of the business, not just its physical assets, like property and equipment.
Several types of professionals can perform business valuations, including business appraisers, investment bankers, and accountants. Qualified CPAs may use their financial expertise to analyse the business’s financial statements and use valuation methods like asset valuation or comparable sales methods.
When do business valuations need to happen?
Businesses may need to be valued at various stages throughout their lifecycles for different reasons. Here are some of the most common scenarios where a business valuation comes into play:
- Selling a business: This is likely the most common reason for needing a valuation. Understanding the business’s fair market value allows you to set a realistic asking price, negotiate effectively with potential buyers, and ensure business owners get a fair return on their investment.
- Mergers and acquisitions (M&As): When two companies consider merging, an accurate valuation of both businesses is crucial. This helps determine a fair exchange ratio (how much ownership each company receives in the new entity) and ensures a balanced deal.
- Attracting investors: If a company is seeking investment to grow its business, a valuation helps demonstrate its potential value to investors. This assures them they’re getting in on the ground floor of a promising opportunity and allows them to understand their potential return on investment (ROI).
- Estate planning and business succession: Business valuations are often required for estate tax purposes, especially if the business is a significant asset. It also helps with succession planning, where the ownership of the business is transferred to the next generation or new owners. Knowing the value facilitates a smooth transition and avoids disputes among heirs or new partners.
- Taxation and compliance: Business valuations can be instrumental in various tax situations. For instance, they might be required to calculate taxes on gifts of shares in the business or determine the value of a business for property taxes.
- Legal disputes: Business valuations can be critical evidence in legal disagreements involving the business, such as divorce proceedings, shareholder disputes, or bankruptcy filings. An accurate valuation protects a business’s interests and strengthens its position in the legal battle.
Factors that affect the value of a business
It’s important to remember that no single factor determines a business’s value. To arrive at an accurate valuation, consider several aspects and other relevant details.
Below is a breakdown of some key factors that affect business valuation.
Financial performance
A business’s profitability is a major determinant of its value. Strong and consistent profits indicate financial stability and future earning potential, making the business more attractive to buyers.
The source and diversification of a business’s revenue streams also play a role. Businesses with predictable and recurring revenue streams from a variety of sources are generally considered more valuable.
To get an idea of a business’s financial health, check its financial performance statements. A historical view of the company’s performance should be reflected in its balance sheet, cash flow statement, and income statement.
Assets and liabilities
The value of a business’s physical assets, like property, equipment, and inventory, contributes to its overall worth. Businesses also have intangible assets or goodwill, like intellectual property (patents, trademarks) and brand reputation, and its rate of amortisation. These assets can be difficult to value but can significantly impact a business’s future earning potential.
On the other hand, a company’s debts and financial obligations can take value away from a business. Higher liabilities reduce the value of the business, as it signals possible risks for potential buyers.
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Market and industry
Businesses operating in growing industries with high demand tend to be valued more highly. Investors are more likely to pay a premium for a piece of a promising market.
General economic conditions and market trends can also affect business valuations. A strong overall economy typically leads to higher valuations, while economic downturns can have the opposite effect.
The level of competition within an industry can impact a business’s value. Businesses with a strong competitive advantage and a loyal customer base are generally considered more valuable.
Future potential
A business’s potential for future growth significantly influences its valuation. Investors are willing to pay more for a business with a clear path to growth and increased profitability. Aside from goodwill and typical physical assets, the experience and capabilities of a company’s management team may also be crucial for inspiring confidence in investors and can significantly enhance a business’s value.
Methods to know how much a business is worth
There is no single correct way to value a business. The ideal method will depend on the business’s unique circumstances, such as size, industry, and financial history. For example, a small cafe would best fit the asset valuation method instead of the market capitalisation method.
Here are some common methods used in business valuations:
Asset valuation method
The asset valuation method focuses on the net asset value of the business. In simple terms, you add up the value of all the tangible assets the business owns (like property, equipment, inventory) and subtract any liabilities (debts the business owes). The resulting amount estimates the business’s worth based on the projected net income from selling assets after paying off liabilities.
This method is good for businesses that don’t rely heavily on future earnings potential, but it doesn’t take into account intangible assets like brand reputation or customer base. Use this method in combination with others below for businesses that rely heavily on goodwill or future growth prospects.
Market capitalisation method
The market capitalisation method, also known as market cap, is specific to publicly traded companies. It multiplies the company’s current share price by the total number of outstanding shares. The resulting amount is a good starting point for understanding a company’s size and worth in the stock market.
The equation of market cap is straightforward:
Market Capitalisation (Market Cap) = Share Price per Share * Number of Outstanding Shares
Market cap is based on market sentiment, which can be volatile and influenced by short-term factors. It doesn’t necessarily reflect the company’s actual or intrinsic value, which considers its assets, liabilities, future earnings potential, and other fundamental factors.
Price-earnings ratio method
The price-earnings ratio method applies to businesses with available stock market data. It involves dividing the company’s current share price by its earnings per share (EPS) to arrive at a P/E ratio. This ratio is then compared to industry benchmarks to estimate the business’s value.
A higher P/E ratio might indicate a higher market valuation for the company’s future earnings potential. A lower P/E ratio may suggest the stock is undervalued or that the company’s earnings are not growing as fast as the industry average.
While it is a good tool, it shouldn’t be used in isolation. A comprehensive analysis should consider other factors like the company’s financial health, industry trends, and future growth prospects.
Earnings multiple methods
The earnings multiple method focuses on the business’s earnings before interest and tax (EBIT). The EBIT is multiplied by an industry-specific multiple to estimate the valuation. The result reflects how much buyers are typically willing to pay for one unit of a company’s EBIT within that particular industry.
Business Value = EBIT * Earnings Multiple
This method considers industry trends and profitability, providing a more relevant valuation than some methods like asset valuation (which might not reflect industry-specific factors). The accuracy of the valuation hinges on a reliable EBIT figure. Unusual or non-recurring items in the income statement can affect EBIT and lead to valuation errors.
Comparable sales method
The comparable sales method also called the “comps” method, involves researching similar businesses that have recently been sold in their industry and location. By understanding the selling prices of comparable businesses, you can get a realistic idea of a business’s market value in comparison.
This method reflects real-world market transactions, providing a valuation based on what buyers are willing to pay for similar businesses. However, it can require significant research to find reliable sales data, especially for niche industries or small businesses.
Publicly traded companies with a market price readily available are not valued using this method.
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Picking the best method for your client’s company valuation
To choose the most suitable business valuation method, consider several factors specific to the business and the reason for the valuation. Use the following for a quick guide.
General guidelines when picking a business valuation method
- For initial estimates: The asset valuation method or market capitalisation method (for public companies) can provide a starting point.
- For a more comprehensive valuation: Consider using a combination of methods. The earnings multiple method combined with Comparable Sales can offer a well-rounded perspective.
Based on the nature of the business
- Public vs. private: Publicly traded companies with a market price can use market capitalisation, while private companies typically rely on other methods.
- Industry: Some methods are better suited for specific industries. For example, the asset valuation method might be appropriate for asset-heavy manufacturing businesses, while the earnings multiple method might be more relevant for service-based businesses.
- Stage of development: Start-ups with limited financial history might benefit from methods that consider future growth potential (like the capitalised earnings method).
Based on the purpose of the valuation
- Selling a business: When selling a business, the comparable sales method can provide valuable insights into market realities.
- M&A transactions: Both comparable sales and earnings multiple methods are often used in M&A deals to determine a fair exchange ratio.
- Attracting investors: Methods that emphasise future growth potential, like capitalised earnings, might be more attractive to investors.
- Taxation or legal issues: For legal purposes or tax calculations, you may need to use various methods and adjustments to ensure a defensible valuation.
Company valuation example
Below is a fictional scenario that best illustrates how multiple business valuation methods can be used together. This is a simplified example. Real-world business valuations involve more complex calculations and adjustments and might require collaboration with professional appraisers for a comprehensive and defensible valuation.
In this example, you’re looking for the business value of a cozy, well-established coffee shop called Brews & Books Brisbane. This five-year business is known for its relaxed atmosphere and a curated selection of books. To get the accurate business value of Brews & Books Brisbane, you would use the following:
- Asset valuation method
- Earnings multiple methods
- Comparable sales method
Using the asset valuation method
Assets:
- Land & Building: $400,000 (based on appraisal)
- Equipment (coffee machines, furniture, etc.): $50,000 (estimated market value)
- Inventory (coffee beans, pastries, etc.): $10,000 (based on current stock levels)
- Cash: $5,000 (from accounting and cash flow records)
Liabilities:
- Business Loan: $100,000 (outstanding business loan)
- Accounts Payable (owed to suppliers): $15,000
Calculations:
- Total Assets: $400,000 (land) + $50,000 (equipment) + $10,000 (inventory) + $5,000 (cash) = $465,000
- Total Liabilities: $100,000 (loan) + $15,000 (payables) = $115,000
Net Asset Value (NAV): $465,000 (total assets) – $115,000 (total liabilities) = $350,000
Using the earnings multiple method
EBIT (from income statement): $80,000 (earnings before interest and tax)
Industry Average EBIT Multiple (for coffee shops): 4 (based on industry reports)
Calculations:
- Business Value = $80,000 (EBIT) * 4 (EBIT Multiple) = $320,000
Using the comparable sales method
Research reveals two recent sales of similar coffee shops in the area:
- Coffee Shop A: Sold for $450,000 with slightly higher revenue but lower profitability than Brews & Books Brisbane.
- Coffee Shop B: Sold for $300,000 with a smaller location but similar profitability to Brews & Books Brisbane.
Adjustments:
- Coffee Shop A might be worth slightly less due to its lower profitability.
- Coffee Shop B might be worth slightly more due to its prime location.
Considering the adjustments, a realistic valuation for Brews & Books using the comparable sales method could be between $350,000 and $400,000.
By applying different valuation methods, we get a range of estimates for Brews & Books Brisbane’s value:
- Asset valuation method: $350,000
- Earnings multiple method: $320,000
- Comparable sales method: $350,000 – $400,000
Considering these results, Brews & Books could be reasonably valued at around $350,000 to $400,000. This range takes into account the value of its assets, profitability, and the market value of similar businesses.
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By equipping your clients with an understanding of these methods and their limitations, you can confidently guide them through the valuation process. But remember, these methods provide a roadmap for estimating value. Collaborating with an appraiser for complex situations or when the stakes are high can ensure a comprehensive and defensible valuation.
So, leverage this knowledge to expand your service offerings and elevate your business relationships. As different clients navigate the ever-evolving business landscape, your expertise in valuation will be a key asset in propelling their success.
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