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Things to Remember when Valuing a Business

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It is important to know the value of a business if you are looking at buying or selling a business.

The problem is that the figure you have in mind and the figure from that of the other party are not the same. If you are the seller, you would probably be disheartened if buyers are not seeing the potential in your business.

The value of a business depends on how profitable it is, and also taking into account the risks involved. However, previous cash flow, lucrativeness and asset values are just the foundation. What provide the most value are the hard-to-quantify aspects such as major business relationships and goodwill.

Influencing factors

The value of a business is affected by the following basic factors:

The reason for selling

Business value can be affected by the circumstances surrounding the sale. A forced sale could slash the value. For instance, a business operator who becomes ill may be forced to accept the first offer he gets, while an owner who is just trying to see what offer he can get can afford to drive up prices, thanks to long negotiations.

Tangible versus intangible assets

It is easier to value a business that has property, equipment, stock available and other tangible assets that have some re-sale value. A number of businesses have nearly zero tangible assets aside from office equipment. But they may have intangible assets that might offer considerable value, such as intellectual property, good customer relationship or well-respected brand. It may not be easy to quantify these intangibles, so seek guidance from your accountant regarding this matter.

Years in business

Businesses that have been operating for years will have a better track record, liquidity and loyal customers who can be relied on for repeat business. Don’t easily trust businesses for sale that have only been trading for one or two years, because they may be “hot” now but the tide may be about to turn, like cafes and bars.

Valuation methods

The real worth of a business is the amount that someone is willing to pay. To determine the amount, various valuation techniques are used by buyers. These methods are normally merely to assure buyers that they’re not paying too high an amount. Here are the primary methods:

Asset valuation

Involves adding up the assets and subtracting the liabilities. For example, a business owns $500,000 worth of machinery and equipment and has $50,000 in unpaid invoices, the business’s asset value is $450,000. A buyer has the option of only purchasing the business assets. By not taking over the business as a going concern, the duty of paying any outstanding debts or tax payments will remain with the former owner. Asset valuation is ideal if you are considering buying a stable, asset-rich business.

The assets listed in the accounts are the basis or foundation for an asset valuation. This is called the net book value (NBV) of the business. To reflect economic reality, you have to refine the NBV amount for the important items, such as fixed assets that may have changed in value, old inventory that may have to be sold at reduced prices, or businesses that aren’t going to be paid.

Usually, intangible things such as software development expenses are not included.

Price earnings (P/E) ratio

The value of a business divided by its profits after tax. For instance, a business with a share value of $40/share and earnings per share after tax of $8 would have a P/E ratio of 5($40/8=5).

You can use this equation: Value = Earnings after tax * P/E ratio. When you have arrived at a right P/E ratio to use, multiply the business’s most recent profits after tax by this amount. For instance, given a P/E ratio of 6 for a company with tax profits after tax of $100,000 would have a business value of $600,000.

It is not easy to decide on the right P/E ratio to use. You will need to rationalise your P/E ratio figure to a prospective buyer or seller. “Standard” P/E ratios are used in some industries, so find out from your accountant the industry averages you can use.

Entry cost valuation

Instead of buying a business, why not set up a similar venture from scratch? An entry cost valuation would give you an idea of what the process would cost you. Here’s how to come up with an entry cost valuation:

Compute the cost to the business of:

  • Buying or funding its assets
  • Developing products or services
  • Hiring and training staff
  • Growing a client base

You can use the amount to draw up a comparative assessment. For example, from the calculation you can see you would need:

  • $500,000 to purchase the set-up equipment
  • $50,000 per month for operating costs
  • 12 months of operation to establish a client base.

Therefore, a company that owns of all these has a value of at least $1.1 million. You can now take into account the cost savings you can make, if any, such as moving to a cheaper location or using better technology.

The major factor in determining how much a business is worth may be something that can’t be easily quantified. It is not easy determining the value of intangible assets because the amount can vary depending on the type of assets or industry. Seek professional advice or guidance from your business advisers, industry association or Chamber of Commerce.

PJS Accountants offers accounting and other booking services to individuals and companies, big and small. Allow our team to evaluate your financial situation and advise you on the right measures to avoid cash flow problems. Contact PJS Accountants for enquiries.