May 2024 Round Up - Business Valuation and Protection
In our latest roundup, we’re delving into two questions that, based on our experience, tend to catch business owners off guard:
“Do you know what your business is worth?”
“Have you taken steps to protect it, and your family?”
It’s funny how we all seem to naturally keep tabs on the value of our homes or superannuation, but when we ask business owners about the value of their business, we’re often met with blank stares.
And that’s understandable. Because the idea of valuing your business has often been associated with something you only do when you want to sell it, or maybe when you’re looking for investors or applying for a loan. But just like keeping tabs on your house and super, your business is one of your most important assets that needs regular valuation, and more importantly, a plan in place to make sure you’re covered if anything unexpected happens.
So, this month, we’re breaking down three simple steps to help you get started:
Value your Business – 5 Valuation Methods
Know your End Game
Protect the value of your business
1. Five methods to value your business
We know that putting a price on a business can be challenging and there’s no single formula for to calculate it. Which model is best for you depends on the nature of your business, its size and the size and concerned risk factors. Today we’re going to give you a few basic guidelines to get you started.
A great starting point for valuation is its profitability, balanced by the risks involved, but if you’d like to take it a step further there are several industry rules of thumb that you can consider to give you a more robust estimate. Today we’re covering the five most common methods we see:
1. Capitalised future earnings method:
The most common method for valuing small businesses is capitalized future earnings.. When you buy a business, you’re buying its assets and the right to all future profits it might generate, known as future earnings. The future earnings are capitalised or given an expected value. The capitalisation rate can be an expected return on investment (ROI), shown as a percentage or ratio. A higher ROI is a better result for the buyer. This method lets the buyer compare different businesses to determine which would give them the best ROI.
To calculate value based on the capitalised future earnings method, first, calculate the business’s average net profit for the past three years, considering whether any conditions might make this figure difficult to repeat. Then, divide the business’s average profit by using an expected ROI considering the sector and the business.
For example, if the expected ROI is at least 50% and the average profit is $100,000, the value of the business can be calculated using the formula below.
Value or selling price = (100,000/50) x 100 = $200,000.
2. Multiples of revenue method:
The multiples of revenue method is a simple valuation method for finding a business’s maximum value. Annual revenue can be considered for a set period of time, and then a multiplier can be used to determine value. The multiple varies by industry and other factors; however, it usually varies from less than one to three or four.
Small business valuation often involves finding the lowest price someone would pay for the business, known as the “floor.” This is often the liquidation value of the business’s assets. Then, a ceiling is set. This is the maximum amount that a buyer might pay, such as a multiple of current revenues. However, the growth potential of a specific business can impact the multiplier. For example, the multiplier might be higher if the company or industry is poised for growth and expansion. A high percentage of recurring revenue and good margins can also boost the multiplier. The multiplier might be one if the business is slow-growing or doesn’t show much growth potential. Economic and industrial conditions can also impact the multiplier.
3. Earnings multiple method:
The earnings multiple method is similar to multiples of revenue. This valuation method can be used to value larger businesses. The earnings before interest and tax (EBIT) are multiplied to give a number, the multiplier. The multiplier can be found by dividing the stock price by earnings per share (EPS) to find the P/E ratio.
The simplicity of multiples makes it easy for most to use. However, this simplicity can also be considered a disadvantage because it simplifies complex information into a single value.
4. Asset valuation method:
This method adds assets such as cash, stock, plant, equipment and receivables. Liabilities, like bank debts and payments due, are deducted from this amount, leaving the net asset value. For example, Raymond wants to buy a manufacturing business. It has $300,000 worth of assets and $200,000 of liabilities. With the asset valuation method, its net asset value is $100,000, so this business is worth $100,000.
The asset valuation method may consider the business’s goodwill on top of the net asset value. Goodwill represents features of a business that aren’t easily valued, such as location, reputation and business history. It’s not always transferred when you buy a business since it can come from personal factors like the owner’s reputation or customer relationships. The asset valuation method may not consider goodwill if the business is underperforming.
5. Discount cash flow method:
The discount cash flow (DCF) valuation method does not consider other companies’ results. Instead, it focuses on your company’s projected cash flow. You’ll give your best cash flow forecast for three to five years. Then, using a formula, you will calculate the present value of those cash flows.
Present value is a concept that compares the business’s current value in terms of future cash flows to how much the purchaser would pay now. This method uses a discount rate, which is the likely interest rate the business purchaser could have gotten from saving the money in a bank account. If your company’s present value exceeds the investment amount, it’s a good investment for the business purchaser.
The projection of cash flow sometimes requires assumptions of future business conditions. Hence, it can be complex and prone to error. This valuation method can be used in conjunction with the other methods.s
