Some owners have a figure in mind of what their business is worth; often it’s inflated because of their emotional attachment. On the other hand, many owners undervalue their business because they do not understand the technicalities of the various valuation methodologies and which of these is most appropriate for their specific business type.
Experience has shown that there is also a large percentage of business owners who do not know what their business is worth, nor how to go about establishing its true market value. Link uses many of the established valuation methodologies, often using a range of different options in combination to establish the most accurate figure. This figure is then further scrutinised by comparing the theoretical value with current and historical sales information from the Link database. This ensures that the valuation appraisal accurately represents what a purchaser will pay in the current market.
Profitability and Risk
Most businesses are valued based on a combination of assets and the cash surpluses generated. The risk factor of the specific business is also taken into account. This is the degree of threat from existing or potential competitors, changes in technology or consumer trends and many other factors that may affect earnings or costs.
“Barriers to Entry” is another issue that is taken into account and involves evaluating the degree of difficulty or barriers a competitor may face should they decide to establish a similar business. For example, businesses which require minimal capital investment or technical knowledge are said to have a very low barrier to entry and consequently, may have a lower value.
Most businesses are valued on a “going concern basis” rather than the value of company shares. Purchasers are reluctant to buy company shares for a variety of reasons including the unknown possible future tax, credit or legal liabilities, or the danger of inheriting contingent liabilities based on historical trading. The price of the business is usually made up of three components:
1. Intangible assets.
The future earning potential of the business reflective of historical earnings potentially including intellectual property (IP), right to products or services, benefits of a lease, contracts, techniques and procedures as well as goodwill.
2. Tangible assets.
The fixtures, fittings, plant and equipment used by the business to generate its income. This component is normally calculated according to its depreciated book value.
3. Stock.
Stock purchased by the business for resale or manufacturing purposes. It is valued at the historical cost price. An allowance may be made for old or obsolete stock.
Valuation Methodologies
Generally, two or more of the following methods are used to appraise the value of a business:
1) Industry Ratios
2) Asset Based
3) Earnings Based
4) Market Based
The appraised value is then subjected to the “sanity test”. Some businesses are in a growth industry where their track record is well established and their projections solid. Other businesses may be in what is known as a sunset industry where projections are less optimistic. Many factors affect the true market value of a business, including business sector, economic conditions, business cycles, interest rates, labour availability and a whole host of other influences. Similarly, the value of trademarks, brands, intellectual property and goodwill is not always easy to quantify. Balancing all these factors with the book valuation of businesses establishes the true market value.
1. Industry Ratios
The value of the business is based on its sales record compared with industry averages. This method is often used for small businesses and franchises where there is an established track record within a specific industry. It may also use a formula of multiples of weekly sales or an average derived from sales of similar businesses.
2. Asset Based
In businesses where there is history of low earnings or perhaps even losses, the Asset Based approach is generally used. Using this method, the value of the collective assets (both tangible and intangible) will determine the value of the business. In many cases there will be an element of goodwill payable, even where a business is not trading profitably. Although the assets alone may be purchased on the open market, there is often value in purchasing assets as a going concern, which may include customer lists, relationships with suppliers, an assembled workforce, brand awareness and reputation, among others. Calculating intangible assets, including goodwill requires some subjective judgement coupled with experience and the use of market comparisons.
3. Earnings Based
Generally the earnings based approach is used for larger businesses and places emphasis on earnings rather than assets. There are various methods used when employing the Earnings Based approach to appraisals. Return on Investment (ROI) or capitalisation of earnings is common, as is the application of earnings multiples.
Earnings Based value is determined by considering:
A. The level of return that could be expected by investing in the business in question, taking particular account of the perceived level of risk and realistic costs of management.
B. The “industry average” multiplier on true earnings. This multiplier is market driven and varies according to perceived industry risk factors, perceived earnings sustainability and historical comparisons. The multiplier used most often in this approach is EBIT (Earnings before interest and tax) but others are frequently used and it is critical that you are comparing “apples with apples” when discussing multipliers.
C. The fair market value of the unencumbered tangible assets of the business e.g. plant, fixtures, fittings, equipment, stock and the tangible and intangible assets which may include intellectual property.
EXAMPLE OF ASSETS BASED METHOD
A dry-cleaning business has been breaking even and the owners would like to sell and move on. The business has tangible assets with a total book value of $135,000, $5,000 of stock (all saleable), no bad debts and will pay all creditors. The fair market value of the tangible assets has been assessed as $110,000 and intangible assets and goodwill at $15,000. Therefore the fair market value of this business is calculated as follows: $110,000 (tangible assets) %2B $15,000 (intangible assets and goodwill) %2B $5,000 (stock) = $130,000.
EXAMPLE OF ROI
Tom’s manufacturing company produced an adjusted net profit of $160,000 (EBPITD). The net assets (Valuation of plant and stock) for the business were $240,000 and a fair salary for Tom (owner) is $70,000. If someone was looking to invest in this business they could expect a 25% ROI, as this business offers a low to medium-risk investment opportunity.
To calculate the ROI value for Tom’s business:
Business profits (EBPITD) ………………………$160,000
Minus owner’s salary ………………………………$70,000
Profit ……………………………………………………$90,000
Return on Investment
Profit of …………………………………………………$90,000
Divided by desired return ………………………………..25%
Valuation appraisal ……………………………….. $360,000
4. Market Based
There will be certain instances where no amount of sound theory or application of complicated methodologies alone will suffice. It is not uncommon that a willing buyer and a willing seller will agree on a value that defies all traditional appraisal methodologies. In other cases the use of traditional appraisal approaches produce unrealistic values that have no bearing on market realities. It is important in any appraisal to overlay relevant market data and multiples achieved in similar businesses “in the real world”. Unfortunately the level of information available in Australasia is not as sophisticated as that available in other parts of the world.
How will taxes affect your pay out?
There are tax issues you may need to consider when selling your business. For instance, if you sell the plant and equipment (or company car) for more than the depreciated book value, you may have to pay back some of the tax you claimed when the items were depreciated (depreciation claw-back). Other tax liabilities may be incurred on the profit of land and buildings if they are included in the sale. It is vital that you fully understand your tax position when selling your business, and professional advice should be sought.
“Any desktop valuation involves a substantial amount of subjective judgment. The real test of the value of a business enterprise, like any asset, is what a buyer is prepared to pay.”