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The Valuation Gap - A Guide to Valuing a buisness

The Ultimate Guide to Valuing a Business - Part 2

Unlike most tangible objects, such as a house or a car, determining the value of a business is complicated

Unlike most tangible objects, such as a house or a car, determining the value of a business is complicated by the fact that there are no truly comparable sold properties to research in most cases. The difference between two companies in the same industry, providing the same service, even with the same revenue, can still be so great that it’s almost a meaningless comparison.

Characteristics such as customer concentration, amount of revenue, geography, management strength, etc, are all big factors in determining a purchase price for a buyer.

This is being further exacerbated by the economic cycle.

In a downturn, for example, buyers are seeking to buy at the rock-bottom price because of the economy. Because of the overall economic situation, they perceive additional risk and seller desperation that would not likely come into the conversation in better economic times. Sellers, on the other hand, may point to deals and valuations from prior to the downturn since it’s not viable for them to exit their business at the price the buyers are offering today.

This "valuation gap" is larger than ever, and it’s unlikely to be effectively narrowed because, as noted above, there’s no real standard for buying companies. Both the buyer and the seller feel the other is being unrealistic, when it’s actually impossible to define what realistic is.

This seeming roadblock can be rectified, however, by a skilled business broker or other experienced intermediary. We’ll discuss more about how that generally works out in the next section.

10 Methods for Business Valuation

Because of the inherent complexity of the task at hand, there are probably far more than ten business valuation methods used throughout the world. Experts may argue semantics or group two or more of the following methods under the same umbrella, but every generalized list of methods you can find is likely to include reference to all of the following:

Industry-based valuation

One rule of thumb for valuation uses a simple formula to estimate the value of the business through pricing guidelines based on the industry it’s in.

For example: fast-food businesses could be historically valued based on 40% of their annual revenue, while motels may be based on a set price of $20,000 per room. Certainly, this method gains instant points for simplicity, but a seller must keep in mind that — even within the same industry — each business has unique qualities which can (and should) raise or lower these set values.

Therefore, industry-based valuation of this nature is rarely used as anything more than a ballpark estimate or starting point early in the valuation process. The exception may be a transaction with extremely tight time constraints or a very low price point, in which neither the buyer or the seller feels a more thorough valuation is worth the time, effort, or expense.

Comparable business-based valuation

With the availability to check out dozens upon dozens of businesses listed for sale online, owners can search for comparable businesses to base their valuation on. This is a great source of free data on businesses that are currently for sale or have recently sold. Owners and buyers alike can look for comparable businesses, then assess what a given business is potentially worse.

If you’ve ever bought or sold a house, you’ll recognize this as the most common means of setting a reasonable price for residential real estate. Buyers and sellers can use the sale price of other similar houses in the same neighborhood that were recently sold to reach a fair asking price.

But, like the industry-based valuation, this method does not work well in valuing a business: because of the natural differences between every company, it’s highly unlikely that even one truly comparable business can be found, much less one with the same number of employees, same basic revenue, same market share, and in the same part of the country, that’s been sold within the past month or so.

Asset-based valuation

The asset-based approach is the most conservative of all valuation models. It is appropriate for businesses such as property companies or manufacturers, where assets form a large percentage of the 'worth' of the business (in the former case, buildings or development sites; in the latter case, expensive tools or machines).

This method gives you a rough idea of the minimum price you can expect to negotiate — a financial comfort blanket.

To use this method, you simply add up the value of your assets and subtract any liabilities. Using the figures in your accounts — the net book value — is a good starting point, but remember that financial advisors are obliged to be prudent; they must give the minimum the assets could be sold for.

You will need to adjust those figures to reflect changing circumstances and market value. For example, have assets gone up in value? Or would they be difficult to dispose of, whatever the original cost? Has your accountant exaggerated the possibility of bad debts? In your calculation of liabilities, remember to include the company's obligations - for example, rent or redundancy payments.

Asset liquidation-based valuation

A variation of the asset-based method would be to determine the liquidation cost of the business. In this method, the value of the business would be based on the estimated cost that any equipment, inventory, receivables etc., would fetch on the open market if sold immediately.

It is often applied to companies with considerable tangible assets, such as real estate properties, but this approach can be misleading if the book value of assets (like buildings and equipment) is inflated for some reason. The problem can be addressed by adjusting the book value to factor in asset depreciation and maintenance or replacement expenses. Fluctuations in market price of real estate should also be considered.

Other variations to the formula include tangible or economic value. Tangible book value is calculated as total assets minus soft assets (those less tangible assets described above.) Economic book value comprises both tangible and intangible assets and adjusts their values according to current market prices.

For a business on the brink of shutting down, this is likely the best of the simple valuation methods, since it clearly itemizes the minimum value the buyer is likely to receive if the company ceases to function following the sale. It’s therefore a popular choice for business sales that take place in lieu of filing bankruptcy or another collapse.

Successful business owners may use this method when buying out failing competitors, with the value being the competitor’s existing stock, equipment, facilities, and/or customer list.

However, the asset liquidation method again falls short in circumstances where the company being sold is still a viable business, or can easily be made such through restructuring or investment. That’s because much of the value in a business isn't included in the raw cost of the business assets. For example, an established customer base, goodwill, brand equity, and future growth potential.

Entry/startup cost

Calculating entry cost gives you an idea of how much it would cost to start and build a business to the same size and with the same profits as the one being sold. To do this, you have to work out how much it would cost to develop the products, recruit and train the workforce, and build up a customer base — all from scratch. Other entry expenses include purchase or lease of the premises, facilities, research and development, branding and advertising.

As a seller, this method requires being brutally honest with yourself and putting yourself in the buyer's shoes: if the business was located elsewhere, or used different raw materials, would it have a lower entry cost?

While this itemized approach attaches a monetary value to hard assets, it fails to effectively account for the intangible components that the owner puts into establishing the business and nurturing its growth. As a result, it tends to lean more heavily toward the buyer’s benefit, rather than being a highly equitable valuation method. It’s often used, therefore, when the seller is highly motivated and/or under a tight time constraint.

Discretionary income-based valuation

Another simple but effective way of valuing small businesses involves determining the current owner’s discretionary income. This offers valuable insight into what a buyer can expect to earn on a monthly or yearly basis (assuming no substantial changes are made to the company’s current situation) and, therefore, what their ROI is likely to be and how long it will take to realize that return.

To determine discretionary income, take the amount the owner has declared on their income tax, add in any discretionary expenses such as automobile expenses, travel expenses, salaries, interest costs for business loans and depreciation (to name a few,). Then, add those discretionary expenses back into the owner’s declared income and multiply the result by 1.5 to 2.5 to come up with the final value for the business. The multiplier provides a significant range in which to negotiate the final price based on intangible items that the equation does not factor in, as described in previous methods.

This valuation method’s greatest limitation is its assumption that the business will continue to operate unchanged after changing ownership. The validity of this assumption depends largely on how the company is currently set up and run. If the current owner plays in integral role in daily operations (rather than a more distant oversight role,) a prospective buyer will need to very careful to determine if he or she can fill that same role in the same way. If not, the discretionary income method of valuation is likely to be misleading.

Price/earnings ratio valuation

The price/earnings (P/E) ratio is one of the most common business valuation methods, and tends to be a go-to strategy for professionals. It's the most common way analysts compare the values of companies quoted on the stock exchange, so sellers and buyers can both place confidence in its validity.

A value is determined using this method by dividing the market value per share by the post-tax earnings per share. So if the value of a single share on the stock market is $1.00 and the post-tax earnings per share are $.05, then the price/earnings ratio is 20. This means then that the business will be valued at $.20 for each $.01 of current earnings. So the higher the ratio, the higher the value you place on the business.

You could look at financial newspapers to gauge historic price/earnings ratios for companies in your sector, and adjust them accordingly — the P/E ratio for a small private company is around half of that of a listed company in the same sector. However, it is very difficult to get figures for comparison for other privately owned enterprises, as the details of the actual deal will remain confidential, with speculation in the trade press or clauses tying in the vendor often inflating the real figure.

It's not always appropriate for smaller, unlisted businesses as it can only really represent the value of established companies with a history of steady profit. A small unquoted business is usually valued at between five and 10 times its annual profit, depending on its history, potential and other market factors; a large, growing quoted company with good prospects can have a P/E ratio of over 20.

Regardless of the size or age of the business, however, it should be possible to get at least a rough range for the P/E ratio, making it a solid choice for most circumstances.

Discounted cash flow

Discounted cash flow valuation is among the more complex methods available, as it focuses heavily on the intangible side of a company’s value. It’s appropriate for companies that have growth potential but lack hard assets and a financial track record. The most common modern day example is the Web-based startup. The method deducts intangible criteria from projected cash flows or NPV (net present value).

Forecasting cash flow is not an easy task, and it’s really far more art than science. “Counting on high projected earnings that don’t pan out” could be an adequate summary of what happened to nearly every failed internet startup in history. However, the gamble works both ways, and sometimes, actual cash flow ends up being far greater than forecast, which is how billionaires are made in the 21st century.

Clearly, the discounted cash flow method of business valuation is not one a DIY entrepreneur or investor should focus on. For the best chance at winning this bet, you should be relying on the professionals.

To calculate the discounted cash flow, establish the estimated profits for a given time period in the future. You then adjust this figure to take account of the diminishing value of money over time. How much would you have to leave in an account, at current bank interest rates, to produce those profits over that period of time?

This will give you a 'base figure' for how much a person might be prepared to pay - but any company will be riskier than investing in a savings account. So replace the bank interest rate with a higher figure reflecting that greater risk (which will produce a lower initial sum).

To help clarify, here’s an example using simple, round figures:

A company makes a profit of $10k annually, which is forecast to remain steady for the next 10 years. Let us assume our potential buyer wants to achieve a 10% rate of return. But $10k received in five years time is not worth the same as $10k received today — because if I received that $10k today I could put it in a bank (where let us assume there is a 5% interest rate) and in five years time it would be worth $12,763. Working backwards, then, $10k received in five years' time is actually worth $7,835 today, whereas $10k in 10 years' time is actually worth $6,139 today. Adding all these figures together will give the buyer an idea of how much he should pay now to receive the returns from the business in the future.

Multiplier valuation by sales

This valuation applies the multiplier method to estimate how much a business is worth. Average sales figures in a particular industry may be used to arrive at a standard multiplier factor. Trade or financial publications, industry associations and business brokers can usually provide current multiples used per industry.

The basic formula is a company's gross sales times the multiplier; for example, $50,000 gross sales x 0.25 multiplier = $12,500 value of the business. The formula may be modified by adding other components to the equation. For a retail business, the value of its inventory is added to gross sales before multiplying it by the industry multiple.

These adjustments require experience and current knowledge if they’re going to effectively reflect the real value of the assets in question. For instance, the stock of a retail store may be overpriced at the moment, as in the case of fashion merchandise whose value declines at the end of the season. In this case, the timing of the sale has a huge bearing on the valuation.

The validity of the industry standard multiplier is questionable because this basis alone does not give the complete financial picture. Companies across an industry vary by size, scope of operations, production output, market share or brand value. Moreover, a host of other differentiating factors, such as cash flow and profitability, are not taken into account.

Multiplier valuation by profits

Alternatively, the multiplier number may be based on a company's profits. The price to earnings ratio can range from five to 10 times the after-tax profit. Small businesses will fall into the lower range, while enterprises with better prospects will be assigned a higher multiple.

Business income valuation seems straightforward and easy to understand, since it uses recent profitability numbers as the benchmark. However, the reported return on investment may not reflect an accurate financial status or looming external threats.

For example, earnings can be overstated by deliberately pending a necessary capital investment. The actual profit margin may not be as high as claimed if the owner has drawn a salary for managing the business. A rival business may set up shop in town, lure customers away and take a big bite of the profit pie.

This is part 2 of our ultimate guide to business valuation.You can read Part 1 here & Part 3 here



Bruce Hakutizwi

About the author

USA and International BusinessesForSale.com Manager for BusinessesForSale.com, a global online marketplace for buying and selling small medium size businesses. The website has over 60,000 business listings and attracts over 1.5 million buyers to the site every month.

@BizForSaleUS

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