Business valuation:Knowing your company’s worth

WHY BUSINESS VALUATION MATTERS
First, let’s address why knowing your
business’s value is essential. This figure
is critical for entrepreneurs and business
owners when making sales, mergers,
acquisitions or raising capital decisions.
Investors and lenders use this data to
gauge the risk and potential investment
return. Moreover, understanding your
company’s valuation can help in strategic
planning, tax planning and legal matters.

Additionally, a precise valuation helps set
realistic employee expectations regarding
stock options and ownership stakes.
For companies that offer shares to
their employees, a current and accurate
valuation ensures that employers and
employees clearly understand what those
shares are truly worth. This transparency
can strengthen alignment between
company objectives and employee
efforts, enhancing productivity and
motivation. It also aids in recruitment

and retention, providing a competitive
edge by attracting top talent who see the
potential for growth and financial reward.

Furthermore, regular business valuations
are instrumental during insurance
assessments and claims. Having an
up-to-date valuation allows companies
to ensure adequate coverage to protect
against losses, whether from physical
assets, business interruptions or
other risks. This proactive approach
can significantly mitigate financial
impacts when unexpected events occur,
providing a buffer that helps maintain
business stability and continuity. Proper
valuation also simplifies negotiations
with insurance providers, ensuring that
coverage terms are fair and reflect the
business’s current worth.

THE FOUNDATIONS OF BUSINESS VALUATION
Business valuation is grounded in
several methodologies, each serving
different purposes and business types.
The three most common approaches
are the asset-based, earning-value and
market-value methods.

ASSET-BASED APPROACH
This method calculates your company’s
total net asset value by subtracting the
value of liabilities from the value of assets.
It’s straightforward and practical for
companies with significant physical assets.
The asset-based approach can offer
substantial benefits during financial
restructuring or in situations requiring
a clear assessment of tangible assets.
This method provides a solid foundation
for negotiations with creditors or during
bankruptcy proceedings, where tangible
asset values are crucial for equitable
settlements. Stakeholders can make more

informed decisions by offering a clear
picture of the company’s physical asset
base, potentially leading to more favourable
negotiation outcomes. This method
also serves well for older, established
companies looking to streamline
operations or divest non-essential assets,
aiding in strategic decision-making to
enhance financial efficiency.

However, the asset-based approach can
fail to reflect the full potential of future
earnings, particularly for businesses in
rapidly growing industries or those with
significant intangible assets such as
brand loyalty, customer relationships
or proprietary technology. For these
companies, an asset-based valuation
may significantly underestimate the
market value, especially if their income is
more about leveraging such intangibles
than capital-heavy operations.

This limitation makes it imperative for such
businesses to consider other valuation
methods that can comprehensively
analyse their true market potential.

EARNING-VALUE APPROACH
Often considered the most reflective of a company’s economic reality,
this method focuses on earning potential. The earning-value approach,
particularly through the discounted cashflow (DCF) method, forecasts
future cashflows and discounts them back to their present value.

The earning-value approach excels in situations where future operations
are critical in determining a company’s value. This is especially
beneficial for startups and high-growth companies where past
financials may not indicate future potential. By focusing on projected
future cashflows, this method helps these companies demonstrate
their value based on growth forecasts and upcoming profitability.
This can be crucial in attracting venture capital or other forms of
investment, as it outlines a growth trajectory that can yield high
returns, making it an attractive prospect for forward-thinking investors.

The earning-value approach also comes with significant challenges.
It heavily depends on the forecasts’ accuracy, making it susceptible
to errors due to overly optimistic assumptions or unforeseen market
shifts. Changes in economic conditions, competitive actions or
regulatory environments can all drastically alter future cashflows
compared to predictions. This method also requires a deep
understanding of financial modelling and market dynamics, which
can be a barrier for businesses without access to skilled financial
analysts. As such, while providing a potentially lucrative view of
future worth, it carries a higher risk of miscalculation.

MARKET-VALUE APPROACH
This method involves valuing your
business based on the selling price of
similar businesses in the market.

The market-value approach is
particularly advantageous for
business owners looking to sell or
merge, providing an immediately
relatable figure based on actual market
transactions. This method can streamline
the negotiation process by setting a
market-tested discussion benchmark.

It also reflects current investor sentiment
and market conditions, offering a real-time
snapshot of what investors are willing
to pay for similar businesses. This can
be invaluable for business owners who
want to ensure they receive fair market
value based on current trends rather than
historical financials that may not fully
capture the current economic climate.

REVENUE AND EBITDA MULTIPLES
While the asset-based, earning-value, and market-value approaches
offer comprehensive frameworks for valuing businesses, another
straightforward and commonly used method involves applying
industry average multiples to current revenue or EBITDA (Earnings
Before Interest, Taxes, Depreciation, and Amortisation). This
method is particularly prevalent in industries where benchmark
multiples are well-established, providing a quick and less subjective
means of valuation compared to methods like the DCF.

For instance, in the accountancy industry, firms often are valued at
multiples ranging from 1.3 to 1.6 times their revenue or 4 to 6 times
their EBITDA. These multiples provide a snapshot of the business’s
current financial performance, making it an attractive option for
owners and investors looking for a straightforward valuation metric.
It simplifies the calculation process and reduces the subjectivity
involved in forecasting future earnings. However, it is important to
note that while this method is easier to apply and less speculative, it
does not account for the future growth potential or downturns of the
business, which might be captured in more dynamic methods like the
earning-value approach.

KEY DRIVERS AFFECTING BUSINESS VALUE
Several factors influence a business’s
value. Market conditions, industry
performance, customer diversity, brand
strength, financial health, revenue trends
and profitability are pivotal. Economic
conditions, such as interest rates and
inflation, also play a significant role.
For example, in sectors like technology,
the speed of innovation and the
competitive landscape can drastically
affect a company’s valuation.

Regulatory environments and legal
considerations can also significantly
impact a business’s valuation. Changes
in government policies or compliance
requirements can alter operational costs
and market accessibility. The quality
of management and the workforce’s
skill level are crucial, as these can drive
a company’s strategic direction and
operational efficiency.

Intellectual property, such as patents
and trademarks, further contribute
by providing competitive edges and
securing long-term revenue streams.
Lastly, global expansion opportunities
and the ability to adapt to changing
global market demands can also
enhance a company’s worth.

PRACTICAL STEPS TO DETERMINE YOUR BUSINESS’S WORTH
To start valuing your business, you can
follow these practical steps.

• Gather financial statements:
  You may need at least three to
  five years of historical financial
  statements, including profit-and-loss
  statements, balance sheets and
  cashflow statements.
• Forecast future earnings: Use
  your financial data to project future
  earnings. Consider market trends and
  how changes in your business model
  could affect these projections.
• Choose the right valuation method:
  Choose the most appropriate
  valuation method depending on
  your business type. You might even
  combine methods to get a more
  accurate picture.

• Consider seeking professional
  advice: Valuing a business can
  be complex and professional
  valuers can provide accuracy and
  insight, especially for large or
  unique businesses.
• Benchmark against other companies
  in the industry: Comparing your
  business to similar companies within
  your industry can provide additional
  context for your valuation. This
  involves examining the sale prices,
  revenue multiples, EBITDA multiples,
  and other financial metrics of these
  companies. Benchmarking can
  highlight competitive advantages
  or challenges and help validate the
  assumptions made during your
  own valuation process. This step is
  particularly valuable in industries with
  a high degree of standardisation,
  where comparable financial data is
  readily available.

COMMON PITFALLS INBUSINESS VALUATION
Avoid common mistakes such as overemphasising historical
financial performance without considering future potential, ignoring
non-financial factors like market position or brand value, and relying
solely on one valuation method without considering others that
might offer a fuller picture.

Neglecting the impact of external market trends and economic
forecasts can lead to inaccurate valuations. It is crucial not to
overlook the effect of technological advancements or shifts in
consumer behaviour that could reshape the industry landscape.
Misjudging the significance of competitive dynamics or failing to
account for potential risks, such as supply-chain vulnerabilities or
changes in consumer demand, can also skew valuation results.

Additionally, underestimating the importance of company culture
and employee morale, which can significantly influence productivity
and innovation, is a common oversight.

Finally, ignoring the potential for scalability or not properly valuing
strategic partnerships can prevent a thorough understanding of a
business’s potential.

WRAPPING UP
Knowing your business’s worth is a powerful tool in your strategic arsenal.
You’re better equipped to assess your business’s true value with a clear
understanding of valuation methods, key value drivers and common pitfalls.
Whether planning to sell, seeking funding or simply looking to understand
your business better, a well-grounded valuation is the first step towards making
informed decisions that drive business success.

Remember, business valuation is not just a one-time exercise but a crucial part of
ongoing business strategy. Keeping up to date with your company’s value can help
you make timely decisions, respond to market changes and guide your business
towards long-term success.

If you need help with a business valuation, contact us today to simplify the process.