Business valuation is the process of determining how much money a business is worth as a whole.
Uses for business valuation
Business valuation is crucial for:
- Anyone hoping to buy a business.
- Anyone hoping to sell a business.
Business valuation is not just beneficial for buying and selling. It can also be used to improve and expand businesses e.g.:
- Expansion - Understanding the current and future value of your business could help you to negotiate bank loans or other methods of raising finance for business growth.
- Disputes - For disputes involving share value, conducting a business valuation could help set the record straight.
- Tax - Business valuation can help you plan tax-efficient strategies.
- Strategy - Having a grasp of where your business is and where it is heading puts you in a perfect position to make sensible decisions for the future.
If you are thinking of selling your business, how do you know how much to sell it for? Do you base your price on the amount of profit your business produces every year? Do you take into account future projections? Is the price based on the state of the economy? Will it be worth more next year than it is now? What about when you buy a business? How do you ensure you're not paying more than the business is worth? How do you go about working out how much it is worth?
Business valuation is a complicated process and you will most likely need professional assistance.
Some accountants offer their services as business valuators. Accountants possess a useful combination of legal knowledge, business understanding and financial expertise - skills that happen to be integral to the business valuation process.
Benefits of business valuation
If you are buying a business, conducting a business valuation on the business you hope to buy could:
- help you to choose a good time to buy
- help you to negotiate a better deal
- help you to complete a faster purchase.
If you are selling a business, conducting a business valuation could:
- help you choose a good time to sell
- improve the business's real or perceived value
- help you to speed up the purchase.
How business valuation works
How is it possible to reduce a whole business to a single value? 'Business' is a very vague term for an often complex structure of constantly changing variables. The process of valuation is essentially the process of converting all of these shifting variables into a single unit, i.e. a number, or rather - a sum of money that can be understood and compared on the market.
Trying to compact all of these changing variables into a single quantitative value is like trying to nail jelly to a wall. In order to understand the complexity of this process, imagine all of the different parts of a business spread out in a diagram on a big piece of paper.
For the business to work as a whole, each component on the diagram must in turn be connected to each of the other components, making a network. This means that when one component shifts, all connecting components must also shift.
Let's say the problem starts with the number of sales a business makes in a month. If this number falls due to extraneous variables (e.g. uncontrollable changes in economy), chances are that profit will fall in tandem. This fall may cause debts to rise and maintenance on equipment to decline. The bad quality equipment could cause employees to leave. This loss of intellectual value could in turn affect the quality of marketing (branding). With public popularity dropping due to inadequate branding, sales could drop even further.
As this example demonstrates, the problems can start from any one of a business's components and affect all others, domino style. This makes it risky to value a business simply on its current profit, because there are so many other factors that could affect profit further down the line. This is why it is so important to take all variables into account during business valuation.
Factors affecting business value
So when buying or selling a business, how do you discern valuable components from invaluable components? Possible components to take into account include:
- Past - Past balance sheets for sales, turnover and profit.
- Present - How well is the business doing now? How well does it control costs? How much money does it make in profit?
- Future - Does the business have any finance plans or forecasts for the future? Can you provide reasoned predictions for how it could potentially be doing in the next 3 years or so?
External variables are factors that remain out of immediate control and could include:
- The state of the economy, including interest rate.
- Patterns of interest in the business's particular market. Consumerism appears to work in trends - can you predict when there will be a demand for the business's product or service?
- Other businesses - similar businesses should share similar values. When valuing a business, it is essential to balance the final value with that of competitors'. The higher the competition, the lower the value. This is known as benchmarking.
- Buyer competition - if there is a lot of interest in a business from potential buyers, the value may increase. When something is in demand it usually increases in value.
Tangible assets and liabilities
Tangible assets are assets that have a physical presence and could include:
- Property - whether office space, storage space or service area.
- Equipment - the worth of any machinery, tools or IT equipment such as computers, printers, fax machines etc.
- Stock-in-hand - is there any previously bought stock you could sell when you take the business on?
- Order book - are there any future orders already put in place?
- Debt - what is the level of debt or other existing liabilities? This needs to be balanced against the value of assets.
Intangible assets are business components that do not necessarily have a physical presence but which still add value. Possible intangible assets could include:
- Goodwill - otherwise known as 'unidentifiable intangibles', including things like the value of the brand itself, e.g. public reception, good or bad reputation etc.
- Intellectual property - this includes any creative or unique inventions the businesses holds the rights to. E.g. designs, patents, trademarks etc.
- People - e.g. managers, owners, (how much does the skill of the owner effect the business? How much involvement should the owner have?) or staff (are they sufficiently qualified, suited and committed to the job?).
Intangible assets: the value paradox
Intangible assets pose a problem for accountants. The value of elements such as employee knowledge, know-how, reputation, research and data cannot be measured in the same way as something like a computer can, but they can still add considerable value to a business.
This is the great business valuation paradox accountants face: how do you measure the worth of an intangible asset?
According to statistics by HM Treasury, UK businesses now invest 20% more in intangible assets than any other asset. This includes things such as:
- brand equity - the worth of consumers' perception of the product or service
- human capital - the worth of workers' combined intellect and skill
- research and development (R&D) - exploring new products, processes and technologies in order to create new products and services to fill gaps in the market
- customer relationships
Economic experts are starting to realise that intangible assets are becoming the main driving force behind modern economic activity. Because intangibles cannot be accurately measured with conventional accounting principals, it is difficult to judge the scope of influence they have. This lack of understanding has resulted in a lack of investment in this area, meaning that a large proportion of the economy is slipping by unaccounted for, simply because it cannot be measured. This part of the economy is known as the 'knowledge economy'.
Business valuation methods
There are a number of different business valuation methods available, including:
This method is recommended for businesses with an established financial history. 'Earnings multiples' is based on the simple principal that earnings should reflect cash flows. Using the earnings multiples method, an accountant will calculate the amount a business is likely to be earning in the future, based on past earnings. The process involves analysing past trends and making adjustments according to a number of factors, including:
- The business's dependency on customers, suppliers, brands or technologies (all of these are subject to change. The higher a business's dependency on them, the higher the risk).
- One-off circumstances e.g. redundancies, write-offs (reduction in recognised value), or litigation matters (any disputes/court cases that could cost money and reputation).
- Profits or losses that could arise on sale of assets.
- Any non-trading income and expenditure e.g. royalties.
- Depreciation charges.
- Tax charges.
This is commonly believed to be the most technical method of business valuation. It relies heavily upon assumptions regarding long-term business conditions. Discounted cash-flow is most suitable for mature, stable, cash-generating businesses. This method of valuation is based on the predicted sum of dividends over the next 15 years or more, plus a residual value, accounting for depreciation over time.
This method does not consider future earnings. It is very simply a case of adding up assets and subtracting liabilities. Asset valuation is most suitable for stable, asset-rich businesses.
Entry cost valuation is based on the amount a brand new business of the same nature would cost to start from scratch. This would involve calculating the costs to the business of:
- raising the necessary finance
- purchasing any assets
- developing necessary products
- recruiting and training necessary employees
- developing a customer base.
Business valuation based on industry
Different industries can have different 'rules-of-thumb'. For instance, the value of a business may be dependent on something other than profit e.g.:
- For computer maintenance, or mail order businesses, this depending factor could be turnover.
- For mobile phone airtime providers, this could be number of customers.
- For estate agents, this could be the number of outlets the business has.
How can an accountant help?
Business valuation is a complex process with strict rules and techniques. Accountants specialising in business valuation are experienced in all methods necessary to reach a fair and accurate value, allowing you to gain control of your business.
To learn more about how accountants work, how much their services cost and how you can find one, please visit our FAQ page.
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