How To Value a Business
While planning to buy a business or sell your own, putting a price on it can be difficult. Just because you believe the business is worth a certain amount does not mean the other party thinks the same.?
When purchasing a company, its worth is decided by how much profit it will generate, even with the risks involved. There is more to business valuation than previous profitability, cash flow and asset values. As a result, business valuation becomes complex.?
To simplify things, here is a guide on business valuation that you can rely on.
Need for Business Valuation
There are a plethora of reasons why you may need a business valuation, such as:
Depending upon the circumstance you are in, you will have to choose a suitable method. For instance, while selling a small company, assets are sold. On the other hand, in the case of a mid-sized company, you sell equity. So, using one method for both cases will be wrong.
What Factors Impact a Business Valuation?
Here's a list of the factors that will impact your business's value:
A company running for a longer duration usually has a higher valuation than a company with a running time of a year or two. For the latter business, the value goes down because the chances of it shutting down are higher, and it does not have a loyal customer base.??
A skilled and efficient staff is the prime need for having a higher business valuation. Having reliable management, where the responsibilities do not fall on a single person, also results in a higher valuation. For instance, a small company with a founder CEO relies solely on this person, which raises a question of its stability in the absence of the CEO.?
This factor is the most obvious one. Businesses that make significant profits are generally valued more. For instance, a gross margin of more than 35% for the manufacturer and over 25% for the value-added distributors comes with a higher business valuation.
If your services appeal to a narrow market or you don't have many products to sell, your business's value will be much lower than a business with products appealing to a broad market or selling a wide range of products.?
Besides, the concept of concentration also impacts the value of your company. Your business may be successful, but you have only a few key clients. Although you enjoy profits from your business, the value will go down in such a scenario.
Why? The answer is the fact that the loss of even a single client will be disastrous. Over-reliance on one person or entity can significantly lower your firm's value. On the other hand, having an extensive client base will have the opposite effect.??
A business's tangible assets, such as machinery, property or physical stock, are easier to value. However, intangible assets like reputable brands or intellectual property are complicated to value.?
A company usually has a combination of both, which are needed to put a good value on your business, regardless of how difficult it is to value an asset. To calculate the values of these assets, you should go to your business advisor or a good accountant.
The legal debts your business owes to a creditor are liabilities. Bank debts, taxes owed, wages owed, mortgage owed, money owed to supplies, etc., are some examples of what can be a liability. In case you wish for a straightforward asset valuation, you can add up all the tangible assets and subtract the liabilities from the resultant value.?
Although such a relationship falls under a company's intangible assets, this also directly impacts the value. The stronger the relations, the higher the value of your company.?
If there are any trademarks or patents under the business’s name, the value of your business can go up.?
Growth potential is a highly sought-after factor for putting value on your business. Attracting and retaining customers is highly appreciated by the buyers, while the opposite will chase them away, thus reducing the value of the company.?
A business valuation is greatly affected by the reputation of your company and its goodwill. Though you cannot have an exact figure for the intangible asset, this factor is still essential.?
Business Valuation Methods
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The actual value of a business is what others are willing to pay for it. But how do they determine a figure? For this, the buyers use various business valuation methods. If you wish to buy a business, you can use these methods to assure yourself that you are paying exactly what it is worth, not more than that.?
Here are the most commonly used methods for business valuation in Australia:
The first method to determine your business's worth is on the basis of assets and liabilities. You can do this by summing up all the assets of the business and then subtracting the liabilities.
For instance, if a business has assets worth $500,000 and liabilities amount to $100,000, then the asset value becomes $400,000.
If you plan to buy the business, consider buying only the assets. This way, you will not need to pay the previous owner's liabilities. You should use this method if you own a stable and asset-rich business or are planning to buy one such business.?
The price-earning ratio (P/E ratio) is the value of a business divided by post-tax profits. Suppose a company has a share price of $60 per share, and the post-tax earnings per share is $12. After dividing these two numbers, the resultant P/E ratio is 5.?
Now, for business valuation, all you need to do is multiply the obtained P/E ratio by the most recent post-tax profit. For the company mentioned above, if this profit is $100,000, then multiplying this value by 5 will give a business valuation of $500,000.?
So, remember to get the business value, you can use this easy equation after calculating the P/E ratio:?
Business value = post-tax earnings × P/E ratio
In this method, the only issue you may encounter is deciding which P/E ratio to use. Choosing an appropriate ratio is indeed a difficult decision, and after choosing one amount, you will also have to justify it to the potential buyer or seller.
To make things easier, some industries have already set their standard P/E ratios when it comes to valuing a business. Hence, it is better to ask your accountant if there's any standard value you should use.?
ROI-based valuation method values your business based on the profits of your company and the kind of return on investment or ROI an investor can get. This method sounds practical because an investor usually wishes to know what returns they will receive on their investment before making it.?
For instance, if a company asks for $250,000 for 25% of their company, the method used for valuation for such a case is the ROI-based method. You get a quick business valuation by dividing the amount by the percentage you are offering. So, after dividing $250,000 by 0.25, we get a business valuation of $1 million.?
As a buyer or a seller, one has to understand that a good return on investment depends upon the market. This makes the business valuation so subjective.?
The capitalised future earnings method is the most used method for determining the value of small businesses. This method will let you compare different firms to determine which would bring the best return on investment.?
While buying a business, you must understand that you are not only buying the current assets but also the potential future profits (future earnings). The future earnings are given an expected value or are capitalised based on the expected return on investment (ROI). For a buyer, the higher the ROI, the better.?
For example, a small company makes an average of $100,000 net profit. The expected or desired ROI is 20%. By dividing these two figures, $500,000 is the resultant business valuation.?
Similar to the previous method, this is also suitable for small business valuation. In this method, you can compare different companies by multiplying the earnings before interest and tax and attaining a value. The 'multiple', i.e., the value to be multiplied by the earnings, can be industry-specific or, in some cases, depends upon the business size.?
For example, imagine a store has an EBIT (earnings before interest or tax) of $100,000, and the industry-specific multiple is 2. So, the business would be valued at $200,000.
The Final Words
Although valuing a business is a complex process, it can be made easy by knowing what needs to be done. If you need expert advice, contact a professional accountant to help you determine this value. At Clear Tax Accountants, you can get the expert advice you need to take your company to new heights.?
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