Quite simply, business valuation is a process and a set of procedures used to determine what a business is worth. While this sounds easy enough, getting your business valuation done right takes preparation and thought.
Business valuation results depend on your assumptions
For one thing, there is no one way to establish what a business is worth. That’s because business value means different things to different people.
A business owner may believe that the business connection to the community it serves is worth a lot. An investor may think that the business value is entirely defined by its historic income.
In addition, economic conditions affect what people believe a business is worth. For instance, when jobs are scarce, more business buyers enter the market and increased competition results in higher business selling prices.
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.
Valuing a business
There are many reasons to determine the value of a business. Knowing what a business is worth is necessary when you are:
- buying a business
- selling a business
- selling a share in a business
- getting a business loan
- attracting investors
- valuing your own net worth.
There are different ways to value a business – some more complex than others – and each method has its advantages and disadvantages. Valuations are usually based on a combination of methods.
Because buyers and sellers often have different ideas about what a business is worth, it is a good idea to get a business broker or professional valuer to assess a business. A well-prepared, balanced and independent valuation can help speed up negotiations and offer a more complete picture of a business’s value.
This article provides an overview of business valuation, including the information you need to gather and the most common methods of valuation.
Information used in a business valuation
In order to value a business, your financial adviser or valuer will need to see at least 5 years (if possible) of financial statements. They may also need to visit the premises to check operations and the business’s assets. They should also consider intangible assets, such as intellectual property, goodwill and the future outlook of the industry, and compare the business to similar businesses on the market.
A complete business valuation will answer the following questions:
Purpose of valuation
Is the valuation for a buyer, seller, lender, investor or other reason (e.g. family estate plan)?
History of the business
- How long has the business been operating?
- How was the business started?
- Has the business changed its goals?
- What is the business’s reputation?
- What is the condition of the facilities?
- What are the job descriptions of all staff?
- Are there any specialist skills required to run the business?
- Is the business reliant on a few people?
- What are employee pay rates?
- How is staff morale?
Legal and commercial information
- Is the business involved in any current or pending legal proceedings?
- Does the business comply with environmental and work health and safety laws?
- Does the business have any long-term commercial contracts? How long are these valid for and how much are they worth
- Does the business have necessary licences, permits and registration?
- What lease arrangements does the business have?
- Is the business making a profit?
- Is there working capital or sufficient cash flow?
- How much of a loan can the cash flow support?
- What has the annual turnover been for the past few years?
- Have the turnover and profit been increasing, decreasing or remaining the same?
- What tangible assets, such as machinery, buildings and equipment, does the business have?
- What is the market value of these assets in their present condition?
- What liabilities, such as unpaid accounts, mortgages, does the business have?
- Does the business have enough working capital to pay shareholder dividends?
- What is the book value – rather than the retail selling price – of the stock?
- What proportion of the stock is obsolete or unsellable?
Goodwill or other intangible assets
- Is there goodwill attached to the business? If so, can it be transferred to a new owner?
- Are other intangible assets, such as intellectual property, for sale?
Market information and industry conditions
- What is the short-term and long-term industry outlook?
- Will specific economic factors directly affect the business?
- Is this market growing, steady or shrinking?
- Who are the business’s competitors?
- Are there any barriers to entry?
- What market share does the business have?
- What is the market price of similar businesses?
- What competitive advantages does the business have?
- What will be the impact, if any, of the departure of the current owners/managers?
Select a valuation method
The real value of a business is equivalent to what buyers are prepared to pay. Before deciding how to value the business, you should establish the prices paid for similar businesses in the recent past. Accountants and business brokers will usually have access to such information. While this benchmarking cannot be treated as a formal valuation, it does provide an initial guide to the likely market price.
There are a number of methods used to value a business. No one method is more valid than another, and valuations are usually based on a combination of methods.
The 2 most common valuation methods are:
- calculating a business’s net worth (i.e. assets minus liabilities)
- valuing based on the business’s income or profits and the expected return on investment (ROI).
Valuation based on net worth
The net worth of a business is essentially the difference between what it owns (assets) and what it owes (liabilities). Assets minus liabilities equals net worth.
When calculating a business’s net worth, you need to consider both tangible assets (such as machinery and equipment) and intangible assets (such as goodwill and intellectual property).
The drawbacks of this method are that valuing a business’s intangible assets can be difficult. Additionally, it doesn’t take into account the premium that might be justified for strong growth businesses or discounts for businesses that are in decline.
Valuation based on annual net profit
Some people prefer to value businesses based on a business’s annual net profit. Many industries have a ratio for valuing a business in this way. For example, the marketplace may value a particular type of business – as long as it’s secure – at 3 times its annual net profit. However, a less secure business in the same industry might sell for only twice the annual net profit.
How to value business assets
A business’s assets are a vital part of any valuation – buyers and sellers need to establish exactly what assets will be sold in any transaction. A business has 3 types of assets, which you will need to consider separately:
- current or short-term assets (tangible)
- non-current or fixed assets (tangible)
- Intangible assets.
Valuing current assets
Current or short-term assets include accounts receivable, inventory and other liquid assets. They’re assets you could reasonably expect will be converted into cash within 12 months.
To value current assets, you’ll need to review the business’s stock on hand and balance sheet.
Valuing non-current assets
Non-current or fixed assets are long-term or permanent business assets. Non-current assets include land, buildings, plant and machinery, tools, motor vehicles and computer equipment.
Non-current assets are usually valued by deducting the accumulated depreciation from the original purchase cost.
For example, if a business bought a computer for $2100 two years ago, this is a non-current asset and it’s subject to depreciation. If the accumulated depreciation for the computer is $1,000 over the 2 years, then the value of the asset now is $1,100.
Sometimes, the depreciated value of a tangible asset is quite different to its market value. It’s important to verify the market values, particularly for high value assets.
Valuing intangible assets
Intangible assets play a major role in valuing a business. They include things like patents, copyrights, goodwill, customer lists and intellectual property (IP). IP is difficult to value as it doesn’t depreciate in the way that a tangible asset does. You should consider seeking professional assistance to value intangible assets.
Key concepts in valuing a business
The following are some key concepts you will need to understand when valuing a business.
Fair salary for owner
Owners who work in their business are entitled to a fair salary for their work, just as anyone else is. This is the concept of a fair salary for owner – the amount you’d pay someone else to do the hands-on work you’d do. This amount includes superannuation.
Keep in mind that fair salary is what you’d be willing to pay someone else to do your job. It doesn’t include additional amounts or an inflated salary you might be willing to pay yourself.
How you choose to treat fair salary for owner in your valuation is very important.
For example, imagine you’re considering buying a business for $100,000 and the annual net profit is $70,000. You discover that this figure hasn’t yet had a fair salary for owner deducted which, given the hours you’d need to work on the business, is $65,000. The net profit after deducting fair salary for owner is $5,000 – the return you could expect if you put your $100,000 in a bank.
Fair return on investment (ROI)
If you have a sum of money to invest, you’ll expect a return on it. If you put it in a bank, you’d get a certain return on that investment (ROI). If, instead of putting your money in a bank, you invested it in a business, the return you’d expect to make would be greater because the associated risks and level of effort required are higher.
Fair ROI refers to the return you expect to receive in the current marketplace for a riskier investment than putting funds in a bank.
The fair ROI you’d expect would be in direct proportion to the risks involved. For example, if you invested in a very speculative business venture with a high degree of risk, you’d expect a very high rate of return if it did prove successful.
Fair return on net tangible assets
A specific example of fair ROI is fair return on net tangible assets. This is the return you’d expect from the net tangible assets of a business.
For example, a business has tangible assets of $200,000, liabilities of $80,000 and intangible assets (including goodwill) totalling $20,000. The net tangible assets of this business are $200,000 minus $80,000, or $120,000. Net tangible assets include only tangible asset minus liabilities.
The fair return on net tangible assets you’d expect to get from this business, assuming you have an expected ROI of 20%, would be 20% of $120,000 or $24,000.
Super profit is the excess a business might return you after you’ve taken out fair salary for owner and fair return on net tangible assets. It’s the amount you’d expect to receive from the business after deducting what you’d receive if you got a job in the business and invested the money you’d spend on the net tangible assets elsewhere.
Super profit = Annual profit – (Fair return on net tangible assets + Fair salary for owner)
For your information:
All of our clients can obtain a short form business valuation service, free of charge annually when their tax returns are completed. Speak with your local senior client director to obtain one today.