Some business owners have a rough idea what their business is worth, but rarely understand the nuances of the different ways to calculate the value of their business. We run through the basics of business valuation 101 and provide some guidance on when to use different business valuation methods.
What is a business valuation?
Business valuations are simply opinions on what someone is prepared to pay to receive the benefits of the business. By it's very nature it is focused on the future earnings or cash flows of the business. And the opinion should never be a single number until someone is prepared to put that amount of money into your bank account. It should be a range of values. (processes and procedures used to determine the economic value of an entity or set of assets.)
Often you hear people say "the business is only worth what someone is prepared to pay for it" - that simply means they don't have any idea how to arrive at some reasoned opinion. They are inadvertently invoking the market valuation method (where you compare your business to a similar business that has recently sold) when that may not be the most appropriate method to use.
There is no single way to calculate the value of a business - it will depend on what you are valuing and the circumstances. That is why you often hear of business valuation methods such as revenue multiples, earnings multiples, asset values and discounted cash flow.
What are the key principles of a best practice business valuation process?
International best practice for valuation services is dictated by International Valuation Standards Council (IVSC), who regularly issue the International Valuation Standards. The Accounting Professional and Ethical Standards Board also issues the APES 225 (valuation Services) standard which all Australian valuers should comply with.
These standards basically require a valuation to be undertaken based on:
Transparency (how the valuation conclusion was arrived at should be clear and transparent)
Independence (the business valuer should be free of any influence through remuneration or other means to arrive at an independent conclusion).
Evidence-based (the information relied upon should be documented and reliable)
Structured process. (the process followed by the business valuer should be clear and documented).
Repeat-ability (can the business valuation be repeated by someone else with appropriate skills and experience using the information contained in the report).
Basically a business valuation should be able to clearly demonstrate:
A concise description of what is being valued, the basis of the valuation, the date of the valuation and the standard of value being used.
What information and assumptions where used to base the valuation upon.
The analysis used to make any conclusions.
Clear demonstration of valuation calculations.
Clear statement of conclusions.
In addition some formal business valuations also need to comply with relevant court standards for expert witness reports and ATO market valuation guidelines.
Key Parameters of Business Valuations
There are four key parameters that must be clearly documented at the start of every business valuation report. These are:
If these parameters are not clear then interpreting the outcomes of the business valuation can become misleading.
Why do we have so many business valuation methods?
The simple answer to this question is because at any point in time the reasons for a business valuation and the nature of the business can vary enormously.
A business can be operating at a loss or a profit, it can be in a high growth phase or an asset development phase or just running steady. The business may also be entirely service based, asset heavy, online, in a specialist market segment that is unique to the world or is providing a commodity service using well established trading platforms.
Because there are so many different types of assets and business circumstances, different valuation methods are required that deal with each situation (or at least try to deal with them).
It is worth noting that when valuing a car, a different approach is used if you are purchasing a standard roadworthy vehicle that will take the family on holidays and a vintage car where there is only 5 left in the world. The same applies to business valuations, which is why it is important to ensure any business valuation meets appropriate standards and
We have gone through the different business valuation methods elsewhere, but have provided an overview of a "simplified process for calculating the value of a business in the diagram below. We have also provided an online guide for calculating the value of a business elsewhere on our site.
For most businesses, the most typical business valuation method is the Earnings Multiple method. But this is only relevant when there is sufficient adjusted ongoing earnings to capitalise. In our experience, at least 30% - 40% of businesses do not have sufficient profits and should use another method.
The ATO considers that the most appropriate method to value a business is to use either the "last money in" or the last funds used to invest in the business that can be linked to a defined equity stake, or they prefer the market method.
In this case the value of your business is based on comparing some key metric (revenue or EBITDA) to other similar businesses that have sold recently. The assumption is that you can find data on suitable comparable businesses. In the private world of small business this can be very problematic and so is usually not considered the most reliable method to use.
In some cases it is appropriate to consider the replacement cost, especially when assessing intellectual property. However the lack of sufficient market data can limit the accuracy of this method.
What is in a business valuation report?
A formal business valuation report has some requirements that it must include in order to comply with the standards and industry best practice. It must also include enough documentation so that the valuation calculation can be repeated by someone else.
So the key headings found in most business valuation reports are:
Scope and parameters
Description of business and circumstances
Analysis of business performance
Key industry and market trends
Glossary of terms
Information used and relied upon
Depending on the business valuation method used, there will be different headings under the Valuation Assessment section. A sample report can be downloaded at Our Processes page
The most important feature is that someone should be able to follow a business valuation report and reach the same conclusions - that is what makes a business valuation reliable and defendable.
Business Valuation 101 - The Basics
Our Whitepaper Business Valuation 101 (What You Should Know About Valuation) explains the theory of valuation, why you need a valuation and the process of doing a valuation. Download a copy and feel free to contact us for an obligation-free confidential discuss.
If you want to know the value of your business and how growth will impact its potential value then give us a call and discuss our business valuation process and the benefits it will deliver.