A business valuation is undertaken to determine the fair value of a business. It is important to get clear on what is the purpose of the valuation, what is being valued and what will the information be used for.
This article will cover why value a business, the different methods of valuing a business and what specifically is being valued.
Why should I have my business valued?
There are a handful of common scenarios where a business valuation is either required or would be a smart move to undertake. These situations include:
- If you are looking to buy or sell a business
- Succession planning
- Certain taxation requirements
- Shareholder disputes
- Family law settlements
- Pre-Employee Share Plan offering
How to value a business
There are a wide range of different valuation methods that apply in different situations. Below I will cover three most common valuation methods:
- Profit x Multiple
- Discount Cash Flow
- Net Asset Value
Profit x Multiple
The most widely known business valuation method would be the Profit times a Multiple (also known as Capitalisation of Future Maintainable Earnings). By Profit we are referring to Earnings Before Interest & Taxes (EBIT). The Multiple is determined based on risk and comparable sales of a similar size/industry.
You will commonly see the Profits (EBIT) being normalised first. What normalised means is that the profit figure is adjusted to remove abnormalities (e.g. bad debts), one-off transactions (e.g. a legal expense) and market rate salaries e.g. (the owner might drastically over or under pay themselves).
An alternate method seen commonly in software business models is the Revenue x Multiple method.
Discounted Cash Flow
The DCF method is mostly used to value a business or asset that is not generating revenue yet but will in future years. A typical example would be a startup business that is investing heavily in team and product development but is pre-revenue.
This valuation method involves forecasting what the future cash flows from the business or asset may be for up to 10 years, factor in future cash flows after the 10 year period (Terminal value) and then discounted (Discoutn rate) all the way back to present day. The reason the cash flows are discounted is because $1 today is not the same as $1 in 10 years time. This is a very technical method of valuation.
Net Asset Value
This method involves calculating the Net Assets from the business balance sheet. There is a risk in this method that it oversimplifies valuation. An alternate method is the Adjusted Net Asset Valuation that adjusts assets and liabilities to their fair value.
There is also an assumption that all assets and liabilities have been fully disclosed and properly reported in the financial statements.
Other variations on the Net Asset Value:
- Net Tangible Asset Value
- Net Realisable Value
- Replacement Cost
- Liquidation Value
What is being valued?
This might sound like an obvious question but in practice it isn’t always that clear. When planning a valuation, an important step is clarifying what you are valuing.
- A particular asset (ie. land, machinery, intellectual property etc.)
- The value of the business (known as enterprise value)
- The equity value
Asset valuation
Let’s say you are looking to sell or license a particular piece of intellectual property. In that case you likely don’t need a full business or equity valuation, just a specific valuation on the piece of intellectual property.
This could be because you want to understand the commercial value or it might be required for taxation purposes.
Business Valuation
The enterprise value is the most common type of valuation where a valuer is determining the value of the business itself.
Equity value
To explain enterprise vs equity value, in the above we saw that enterprise value is the value of the business itself.
When talking about equity value, that business might be run through a company structure that has shares on issue, and that company also has cash in the bank, and accounts receivable owing, and plant and machinery and some bank debt.
So in practice a buyer could just buy the enterprise off you (and you keep the company with the cash and receivables and so on) or they could buy the shares in the company off you (equity value) that contains the business and other assets and liabilities.
So when we are valuing equity we are determining in this example, what are the value of the shares in the company.
Key Takeaways
BJT Financial assists businesses with tailored business advice including outsourced CFO, buy/sell business, financing and cash/profit improvement enquiries. If you require assistance with your valuation, contact BJT Financial’s advisors on the below form.
