Search Businesses For Sale|Add Listing|Valuation Appraisal

Valuations

How to value a business?

Determining the value of the business is one of the most difficult things the owner will be required to do and the seller will be required to verify. There are a number of reasons why a fair and accurate assessment of business worth is required, ranging from determining a selling price to raising investment capital.


Fair market value

The courts definition of “fair market value” is the price a willing but not anxious buyer, acting at arm’s length, with adequate information, would be prepared to pay to a willing but not anxious seller of the shares or assets in question. This means that if all information on the asset in question is provided to an interested party and the seller is logical and forthright in the sale of their asset. The fair market price is the price agreed between both buyer and seller on that day.

The statement mentions that both the buyer and seller should not be anxious in relation to the sale of the asset. Implying that they should be logical and forthright when approaching this transaction. From the outset, it’s important to note that the business owner may be the least capable person of deciding how much the business is worth, as they may have personal and emotional ties to the asset in question that will not allow them to look at the transaction in a clear objective way.

Additional to this, there may also be buyers that are not acting objectively towards the transaction and may significantly under or over value the business. (Please note it is extremely rare to find a buyer that overvalues a transaction). The reality is that most of these types of buyers waste time and energy of the parties and their representatives involved. The best way to deal with this type of problem is to put a qualifying system in place that weeds out time wasters. Business brokers specialise in this type of service.

The term adequate information is used in the above statement. What is adequate information? In the case of business sales this may reflect historical and current financial information, current operations covering supply arrangements and customer arrangements, advertising etc… (for clearer understanding of what type of information is usually supplied please read the article in relation to business profiles).

When the owner or prospective purchaser is in an objective mindset and has reviewed all of the available information then they will be able to proceed to applying a valuation to the asset.

Intrinsic value

Initially it is important to determine the bottom value of the business. This is generally regarded as the current market replacement cost of all the plant and equipment and stock involved in generating income (intrinsic value). That is, if the business was to start again, would a new owner still have to purchase all of the stock, plant and equipment the business currently holds.

Goodwill

Goodwill is the component of price above the intrinsic value of the business. The next steps will help in determining if there is any goodwill value in addition to the intrinsic value associated with the asset. To do this the seller/buyer must consider risks associated with running the business. That is what are the risks associated with the business?

Risks

Risks include key employee risk (including owner/s), supply risks, customer risks, economic risks, technological risks, systematic risk, market risk and tenure risks. (There may be additional risks associated with the business not mentioned in this article.)

• Key employee risk – is risk associated with key staff members or owners. There are a number of components to this risk. The first is how much does the business rely on key personnel (including the owner)? Would it be difficult to replace them without detriment to the business? Can they easily be replaced at a fair market rate? Are they being paid the fair market rate now? Will any negative / positive answers to these questions affect the profitability of the business?

• Supply risks – is risk associated with supply arrangements. There are a number of components to this type of risk. What choice of suppliers are available? Are supplier terms transferable to the new owner? If they are not transferable will that increase working capital required? How will this affect the value?

• Customer risk – is risk associated with customers. There are a number of components to this type of risk. Are sales distributed evenly amongst the customers? What percentage of sales do the top 5 and top 10 customers hold? Do the biggest customers choose the business due to price, quality, customer service or convenience? If the business lost the two biggest customers would that significantly change the profitability of the business?

• Economic risks – is risk associated with the economy. There are a number of components to this risk. How effected is the business in relation to local, national or regional economic conditions? How likely are economic conditions to change? Will this effect the profitability of the business?

• Technological risk – will products or services offered be eliminated through technological innovation? If yes, when is this innovation likely to occur? Will technology help the business to grow? How technologically driven is the business? How technologically driven are the competitors? Does this require further investment into equipment and training? Will this affect the profits?

• Systematic risks – this risk is associated with the systems that the business currently employs. Are these systems affective? Are these systems easily transferable? How much of the business is systemised? How much requires executive decisions? Are there better systems available? How easy is it to learn these systems?

• Market risk – This is risk that is associated with the market the business operates in. The first thing to consider is where does the business conduct its operations? Manufacture, wholesale or retail. How many competitors are there in that market? Is there anything that differentiates the business from the competitors?

• Tenure risk – this is risk associated with continued tenure. Are the premises currently leased? How long is the lease guaranteed for? Is the business paying fair market rate? Will the business have to move premises soon? What are the additional costs associated with moving or creating a new lease or paying fair market rate? Will this affect the profitability of the business?


Once the risk set has been determined it is useful to look at the likelihood of these things changing in the immediate future. That is, what is the likelihood the business will become more or less risky in the coming years? Once all of these risks have been identified in respect to now and the immediate future the next step is to determine the profitability of the business.

Profitability

Different businesses are sold on different profitabilites. There are many measures of profitability some of which are Net profit, EBITDA, EBITD, EBIT, PEBITDA, PEBITD and PEBIT. (Please refer to the article in relation to definitions for further clarification of these terms). Each one of these terms attracts a slightly different valuation technique.

Rule of thumb method

One of the most widely used forms of business valuation is based on the rule of thumb method that determines value according to a standard for businesses in the same industry. Every industry has benchmarks that industry insiders use to gauge the value of the businesses. The problem is that the benchmarks are based on industry averages and don’t take into account the extenuating circumstances of any given business. So, while the “rule of thumb” method is good for ballparking the value of the business, the seller/buyer will need to rely on other methods to determine its final value.

Book value method

The next most popular method is the book value method. Book value of a business is based on the accounting records and is determined by subtracting the company’s liabilities from its assets. The result is the owner’s equity (book value). Adjustments are then made for things that aren’t reflected in the financial statements like intangible assets and market factors.

Earnings capitalization method

The earnings or income capitalization method is based on determining an annual rate of return necessary for taking on the risk of the investment. Most business owners would recognise this as some multiple of profits. This is an approach to determine the return an investor would wan to hold your asset in the market place when compared to other assets. The return is the inverse of the multiple. That is a 3 times multiple means a 33.33% return on investment. Rates of return vary according to the amount of risk involved. According to this method, the value of the business is determined by the size of the investment necessary to earn the required rate of return when it is compared against the business’ earnings.

The easiest way (but not necessarily the most accurate) to determine the capitalisation rate is to research other businesses for sale. Look as listings on the internet to get an idea. You can also approach a broker for an appraisal or enlist the services of a valuer to give you a more accurate price.

Business brokers and valuers have a historical database of past sales that they can compare the business too. They also have the expertise of the industry to determine what price is likely to be achieved for the business. They make adjustments to values in relation to the current market.

Other issues

Finally, the value of time has to be taken into consideration. How long does the owner want the business on the market for? There are many components to this question. The longer the business is on the market the more likely the owner will have to drop price to meet the market. It is not useful to set a high price for your business and reject prospective purchases only to have to approach them again at a later date. This can send them a signal that the business is less valuable and lead the buyer to a lower offer. If however, the business fits into a small minority and the appropriate price can only be achieved through a longer process then this approach should be used. This certainly might be the case if you have a large value business.

In summary the valuation must take into account the following:

• The time to sell the business.

• The risks associated with the business.

• Type of business.

• Historical and current information of the business.

• Likely future expectations of the business.

 

Log in
Username
Business Sales Password
BusinessSales.com.au password retrieval Remind