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What is your business worth?

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What is business valuation?

Business valuation is a process and a set of procedures used to determine what a business is worth. Is it an art or a science?

Science is often seen as precise, and art as interpretation. In fact it is a bit of both.

You can try our free business appraisal by contacting us today to get an idea of what your business may be worth quickly.

Getting your business valuation done right takes preparation and thought. And at the end there is no correct answer. At the end of the day the value of the business is the point where a willing buyer and willing seller meet and agree on a price (see also our blog on value is in the eye of the beholder)

However these three methods give great guidelines on how to value a business.

The circumstances of a business sale also affect the business value. There is a big difference between a business that is shown as part of a well-planned marketing effort to attract many interested buyers and a quick sale of business assets at an auction, known as a fire sale.

Three business valuation approaches

That said, there are three fundamental ways to measure what a business is worth:

  • Asset Approach
  • Market Approach
  • Income Approach

Asset approach

The asset approach views the business as a set of assets that are used as building blocks to construct the picture of business value. The asset approach is based on the replacement cost which addresses this question:

What will it cost to create another business like this one that will produce the same outcome for its owners?

Since every operating business has assets and liabilities, a natural way to address this question is to determine the value of these assets. The difference is the business value. However a business valued at or less than  its asset value is generally seen to be undervalued and is often viewed as a break up target as the sum of the parts may be greater than the sum of the whole.

Asset value is generally more relevant where the assets are the key determinant of the income stream of the business, as the value of the assets is linked to the income stream. i.e. equipment rental. It may also be used where the assets are intellectual property, where no income is generated but the potential for value is in the IP ownership.

However these values still comeback to what someone is prepared to pay, not necessarily what the accountant has recorded in the accounts.

Market approach

The market approach, as the name implies, relies on signs from the real market place to determine what a business is worth.

What are businesses similar to my business worth?

If you are looking to buy a business, you decide what type of business you are interested in and then look around to see what the “going rate” is for businesses of this type.

If you are planning to sell your business, you will check the market to see what similar businesses sell for.

In many cases this will come back to looking at industry equivalents that translate back to either a multiple on sales or earnings.

That mythical beast the fair market value is often quoted as the most appropriate valuation method but until you put it to the test it is always mythical!:

The business price that a willing buyer will pay, and a willing seller will accept for the business. Both parties are assumed to act in full knowledge of all the relevant facts, and neither being under obligation to conclude the sale.

Income approach

So unless you are selling strong IP or rare assets then you are inevitably going to come to a revenue or income based approach to valuation.

You are always looking at the past performance of a business to determine how it will earn money for you in the future.

This can be done by either applying a multiple to current numbers or by looking at future earnings.

Since the business value must be established in the present, the expected income must be translated to today. The income approach uses two ways to do this translation:

  • Multiples
  • Discounting

Business valuation by multiples

In its simplest form, this method basically divides the business expected earnings by the so-called “capitalisation rate”. The idea is that the business value is defined by the business earnings and a multiple rate is used to relate the two.

For example, if the multiple rate is 33%, then the business is worth about 3 times its annual earnings.

The capitalisation rate is often also called multiple. The whole stock market works on multiples for the majority of its valuation, and this offers the easiest method of valuing a business. But how do you determine the multiple? 

Valuation of a business by discounting its cash flows

The discounting method works a bit differently: first, you project the business income stream over some future period of time, usually measured in years. Next, you determine the discount rate which reflects the risk of getting this income on time.

Finally figure out what the business will be worth at the end of the forecast period. This is called the residual or terminal business value. Finally, the discounting calculation gives you the so-called present value of the business. Of course how you arrive at the value of the business is a big determinant of the present value. There is some school of thought that ignores this, however this is a key factor for the buyer and should not be ignored.

If this is all sounding a little complex, don’t worry, we offer a completely obligation free appraisal of your business so that you can make a more informed decision moving forward. Just click here to book in. 

If your business shows smooth, steady profits year to year, the capitalisation method is a good choice.

For a growing business with rapidly changing and less predictable profits, discounting gives the most accurate results.

Why business valuation methods produce different results

Is it possible to use the income business valuation methods and arrive at different results? The biggest determinant is risk.

Each buyer will likely have a different perception of the risk involved and may have different plans for the business, which will affect how they project the income stream and therefore value the company quite differently. Hence understanding what your business will do for the buyer is part of understanding the value equation.

As a follow-on to this targeting a specific group of buyers who can extract more value from your business should lead to a higher exit value.

Contact us for a free half-hour initial meeting.

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