The basic mechanics of a business valuation

business valuation

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Understanding the basic elements to a business valuation exercise can put you in a better position to assess proposals for your business, and for potential future transactions where its value is involved.

There is a wide range of reasons why you may need to attach a value to your business. While a simple web search for “how to value a business” will produce plenty of methodologies, approaches, tips and “rules of thumb”, the bad news is that only some of these will be appropriate to value your business.

Common elements to all valuations

Generally speaking, business valuations aim to place a fair value on a business. Just like there are many different types of businesses, there are many different valuations methodologies and approaches. However, they all share some common elements and underlying principles.

Cash is king.
A valuable business is one that demonstrates healthy, reliable cash generative ability. This is often referred to as Free Cash Flow (“FCF”) and is broadly a measure of the cash that is available to investors in the business. FCF is itself quite a broad topic, but the common thread is consistency: businesses that generate consistent cash flows tend to attract higher valuations than those that don’t.

The past does inform the future…to some extent.
Historical business performances (sales, expenses, profits) is not a perfect indicator for future projected performance. The future is unknown, and the business itself grows and matures. However, while there are plenty of good reasons for a business to lift its margins from 10% to 25% one year to the next, and unless drastic changes to improve these margins are clearly and defensibly justifiable, it is possible that a business valuer will ignore such fanciful upswings.

Is the business adequately resourced to deliver?
This is particularly critical for growing businesses, but remains just as valid for established ones. Resourcing refers to staff, key persons and experts, supplier lines, funding and even property space. Businesses that are heavily dependent on a single key person are at higher risk and tend to attract lower valuations. Business projections and forecasts that depict 200% growth in profits, but do not match that with increased sales, support staff or office space are immediately questionable and weaken the valuation position.

A business story that makes sense.
Company valuations are about more than just the numbers. Valuations should capture both the quantitative and qualitative aspects of the business, as well as the context in which it operates. Forecasting sales growth in an objectively shrinking industry, planning for zero bad debts across a book of a thousand clients and assuming that the current staff complement is sufficient to service 4-5 times the business volume are common mistakes that many business owners make. These assumptions have a positive impact on the valuation numbers, but taking a step back and thinking through these statements rationally, it is clear that the business does not have a consistent, reasonable and well thought out plan for the future with the valuation impact applying as a consequence.

Forward-looking versus backward-looking valuations
Most methods will fall into one of these two buckets. Each method has its pros and cons, and some methods are better suited to some businesses than others. However, regardless of the approach, one should always test whether backwards and forwards looking measures are illustrating similar results. Nevertheless, even though they will almost never match, there should be a sensible explanation for drastic differences between the two.

Backward-looking valuations rely on historic business performance as a means of estimating future performance. These methods include revenue and earnings multiples, cost to replicate, balance sheet and NAV (Net Asset Value) based methods as well as extra earning potential and return on investment measures. They are typically simple to calculate, as they are derived primarily from information that is available, such as annual financial statements and management accounts.

Forward-looking methods tend to be more complex to carry out. They are built on forecasts of future sales, expenses and profitability, and as a result are reliant on the assumptions that are made about the business. These methods allow for additional detail about the business to be accurately captured in the valuation price, such as the recent introduction of a large client, significant periods of planned growth, new product lines and changes to the business capital structure. Common forward-looking methods include discounted cash flow methods, of which there are a wide range of variants available.

Be clear about the purpose of the valuation
There are many reasons why a valuation needs to be undertaken. These include buy/sell discussions, introducing a new partner or shareholder, succession and estate planning, capital raising and even for tax and divorce calculations.

Understanding the purpose of the valuation is critical. In each case, the parties that will be reviewing and engaging with the valuation differ and their motives will differ substantially. Buyers would push for lower prices while sellers would push for higher prices; succession and buy/sell planning is more about equitable treatment of shareholders, and estate planning will place greater focus on the tax and inheritance implications for the business owner.

However, business valuations are not silver bullets. There is no single right price for a business, and invariably, different parties will almost always arrive at different valuation results. The key to arriving at a conclusion to any discussion (whether it be with the tax man or a new investor) is understanding the objectives of each party and selecting the approach and valuation basis that is best suited to achieving those objectives effectively.

Using valuations in buy/sell discussions
A quality valuation report can be an invaluable tool for any party entering into buy or sell discussions. For a business owner looking to sell their business (or a part thereof), a detailed valuation exercise will highlight the aspects of the business that contribute positively to the valuation and will allow the seller to motivate for the highest price.

Conversely, a well-equipped buyer will have a better understanding of how the business has delivered results and the assumptions/expectations that would need to be play out in order for the buyer to realise a suitable return on their investment.

Business owners that make the effort to obtain regular valuations for the business will have a far better chance at growing and building their business over time in such a way to optimise their selling price. The same way that one may maintain and service a car in order to preserve its sale value, business owners should use valuation exercises as a means of ensuring that they are continuously building a saleable asset.

When to DIY your valuation
The internet presents all of us with an abundance of information and resources at the click of a button. It is therefore relatively straight forward for any business owner to carry out a valuation exercise themselves. Indeed, many online tools exist where business owners can obtain a free report in a matter of minutes and this can be a good way for business owners to get a handle on the different methodologies and approaches available.

However, just as one would ask a doctor to step in when symptoms get a bit too serious to be safely addressed by a web search, business owners should seek the right input and advice when they find themselves with transaction discussions and material decisions involving their business. Some of the key benefits of hiring a professional to carry out a business valuation include:

Objectivity and independence. Business owners are notoriously (and justifiably) biased when it comes to their own business, and tend to overestimate potential, underestimate expenses and exaggerate sales potential. This is a negative to a potential buyer that necessarily needs an objective and pragmatic view for potential performance.

Blind spots. A fresh set of eyes will typically highlight areas or aspects that business owners are too close to see or choose not to see. This can assist the business owner in identifying weak spots in the value proposition, as well as helping them justify and validate the value that they have built.

Experience. Valuation professionals have typically valued a range of businesses across a range of industries and can provide a view of the business that business owners simply cannot achieve themselves.

The right valuation partner
The right valuation partner can be a tremendous asset to your business. Much like a trusted mechanic, they can assist business owners in ensuring that their business is managed and grows in a way that accrues maximal value over time. When looking for a valuation partner for your business, test their backgrounds and ask to see some previous valuation reports. There may be a premium to be paid, but this should be comfortably offset by an enhanced outcome to any future discussions.

Gareth Watson is an actuary, consultant and co-founder of iBizValue, a firm specialising in business valuations and corporate finance projects for small to medium companies.

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First published on: ForbesAfrica