Business valuations – The fundamentals all business owners should know (part 2)


So last week we looked at the first 2 steps of business valuation, namely what are you valuing and why. We’re going to continue this week by looking at the next two valuation fundamentals, when to value your business and how to value your business.

So let’s get straight into it:

When to value your business?
Seems like a pretty straightforward question, doesn’t it? Well it is pretty straightforward but at the same time, very important.

The purpose of the valuation will determine when the valuation should be conducted.

For example, in a family law matter, the date of valuation should be the point at which the divorce is finalised by the judge. In terms of a valuation for accounting purposes (for example, an impairment review) this would have to be at the financial year end of the company or business being valued.

I would suggest you seek professional advice on this simple but important matter.

How to value your business?

Well, I could talk all day about this but for now let’s keep it simple. When valuing a business we normally use one of three methods, namely:

  • Earnings based approach
  • Discounted cash flow
  • Asset based approach

There are various nuances relating to each of these methods but let’s look at each one in turn.

Earnings based approach

An earnings based approach, as the name suggests, takes the earnings of the business and multiplies this by an earnings multiple to calculate your business value. It’s an ideal method for a mature business with a track record of historic profits. Again, it seems pretty straight forward until you ask yourself the following questions:

  • Which earnings do I use (Earnings Before Interest & Tax, Earnings Before Interest, Tax, Depreciation & Amortisation, Profit Before Tax or Profit After Tax)?
  • Do I use historic or forecast earnings?
  • Are my earnings sustainable or do they include a number of one off items of income or expenditure?
  • Which multiple should I use and how do I determine it?
  • Where do I get earnings multiples from and do I need to make any adjustments to these multiples?

As you can see when you start asking these questions the complexity starts to emerge.

Discounted cash flow (DCF)

DCF valuations are probably the most scientifically sound but still have their problems. The DCF method takes your future cash flows and discounts it back to present value.

The simplest way to think about present value is to ask yourself the question, would you prefer $1 now or $1 in a year’s time? Hopefully you would like the $1 now because it’s worth more than the $1 in a year’s time. The reason for this is because you could invest that $1 in an investment account and earn interest so that by the end of 1 year it could be worth $1.03 for example. The longer you go out the less that money is worth in today’s value.

A DCF takes all of your anticipated future cash flows and discounts them back on a similar basis to present value. The problem is of course that the result of the DCF valuation will depend on the inputs into the valuation, namely your future cash flow forecasts, i.e. RUBBISH IN, RUBBISH OUT.

The other problem with a DCF valuation is that it is recognised that in theory cash flows run in perpetuity (i.e. forever) and so even though your cash flow forecast will stop after 3 or 5 years the valuer may still take a view on cash flows after that. This value in perpetuity can account for a large portion of the overall valuation result even though there is nothing to substantiate it and hence this causes a lot of debate.

Asset based approach

An asset based approach is ideal where the item being valued has a market value that is easy to determine. For example, when valuing an investment property, you could either use an earnings basis and take the net rental divided by the market yield to determine a market value or you could just look at the value that similar properties have sold for in the area to determine the market value.

The same would apply for other assets such as motor vehicles, trucks, commercial property etc.

Conclusion

Valuations can be a complex issue and although we believe in keeping things simple we would caution against taking the easy way out when it comes to business or company valuations. You can easily miss the boat completely.

The best thing to do when encountered with a business valuation is to seek professional advice from people who value businesses for a living.  Do your research and look for those valuers who are able to add substance and rigour to a valuation process so that the valuation itself can stand up to scrutiny for other parties.

Contact Lattice Capital on info@latticecapital.com.au for more advice on valuing your business.

Business valuations – The fundamentals all business owners should know

valuing your business, how to value your businessWhat does a business valuation actually involve?  Do I need one?  Well, if you need to know what your company’s value is, a business valuation is a good place to start.

We’re going to take a closer look at business valuations and specifically the 4 steps to valuing your business.

 

 

Part 1:

  • What are you valuing?
  • Why are you valuing it?

Part 2:

  • When are you valuing it?
  • How are you valuing it?

What are you valuing?

Seems like an easy question, right? Well this is where many business valuations fall at the first hurdle. This is one of the valuation fundamentals and if you get this wrong, the whole valuation will be wrong and that could end up costing you a lot of money.

Business vs company valuation

The most popular area of confusion is business vs company valuation. Most people see these as one and the same but they are in fact very different. A business typically operates within a company and sometimes there can be a number of different businesses operating within the same company.

business valuation, valuing your business, how to value your businessA business has a number of assets and liabilities associated with it that the business needs to continue trading; things such as debtors, stock, plant and machinery, etc.

The company on the other hand, has a number of things, independent of the business, that it needs to operate and this is normally related to the capital structure of the company; things such as debt and shareholder equity and loans.

If someone wants to buy your business, they are not interested in the capital structure of the company, they don’t want to take over your debt, your shareholder loans and your historic tax liabilities.  All they want are the assets they need to continue operating the business and required to generate the cash.

Sometimes though buyers want to buy the company (for various reasons) and in those circumstances they do want the debt and shareholder loans. This could be the case, for example, where the company has some contracts that cannot be transferred to another company and so a buyer has no choice but to buy the company, i.e. the shares.

Value drivers

The other area of confusion is caused by not really understanding what drives value in your business.

Let’s look at a simple case study to demonstrate this:

  • You run a pest control business from a property in central Brisbane that is also owned by the company; and
  • The business needs the property to operate from and you intend to sell the property with the business.

In this case you can’t just value the business using one methodology, such as an earnings based approach (more on that in later posts). You need to value each different aspect of the business. Firstly, you need to value the business on its merits and then value the property separately.  The two valuations are then combined as they are both owned by the same company.

You will probably need to make a few adjustments to your numbers to achieve this. As an example, you will have to impute a market related property rental for the use of the property into your business expenses and then exclude all other property related expenses from your business expenses.

It’s vital to break a business down into its respective parts and then you can determine the best way to value each piece.

Why are you valuing it?

So now you know what you’re valuing it, the next question is why are you valuing it?

This is important as it will determine your approach to the valuation. There could be a number of reasons for valuing a business including:

  • Sale of the business as a going concern
  • Forced sale due to pending bankruptcy
  • Taxation purposes

Your reason for valuing can have a dramatic effect on the valuation result. If you are forced to sell the business due to pending bankruptcy then it is important to be able to sell it quickly. When you do that, you have to expect to apply a discount on some asset values.

So make sure you understand the purpose of your valuation and the impact this will have on the valuation result.

Conclusion

Getting these valuation fundamentals right will set you on the right path for determining your business valuation. If you don’t consider these fundamentals you run the risk of under-estimating the value of your business and potentially selling it for less than you should have, and that’s a direct impact on your back pocket. Alternatively you may not be able to sell it at all because your valuation expectations are too high.

So before you start valuing your business think about the above and be absolutely sure about the what and why of business valuation. Don’t be afraid to seek professional advice if there is any element of doubt.  Do you have any questions on what a business valuation is and why you need one?  Post your questions or comments below.

Join us next week where we’ll take a look at the next two steps of when and how you value your business.