Source: By Chris Nobbs
Many of the planned exits from a business require that a valuation be undertaken. Naturally when you do this you will be getting guidance from your accountant but it can be very helpful to understand the basic methods used to value a business. These include:
The Profit Valuation Method
The Asset Valuation Method
Discounted Cash Flow Analysis
The Profit Valuation Method
One way of getting a broad estimate of the value of a business is by multiplying the net profit before tax by a given factor. The chances a business has of being successful will determine this factor.
Past financial statements and income tax records are one way of working out the net profit of a business. Certainty can be increased by investing a week standing by the till (or its equivalent), keeping track of the amount of money being paid by customers.
All businesses have different chances of succeeding. Those more likely to be successful (or perceived to be more likely to be successful) will probably be relatively more expensive to buy. For example a newsagency, which is traditionally seen as being a very secure business, may be worth three times proven net profit. On the other hand, restaurants are seen as less secure and may sell at only two times the proven net profit.
Other factors can influence the value of a business. Consider two restaurants, both having a net profit of $ 80,000 a year. If restaurants are selling for two times net profit, then both businesses should be valued at around $ 160,000. But what happens if the first restaurant is in a community where the population is growing and the second is in a community where the population is decreasing. All other things being equal, and given that both restaurants are on the market for $ 160,000, the first is likely to be the better buy.
The Profit Valuation Method is commonly used but is not based on sound financial management principles and should never be regarded as anything more than a ‘ball-park’ indication of the true value of a business.
The Asset Valuation Method
Another commonly used method, and one used by many accountants, is the Asset Valuation Method. It involves assessing the value of the assets that will be transferred on the sale of the business. These may include equipment, furnishings and stock.
Sometimes the value of the business will be greater than the value of the net tangible assets (fixed assets, stock on hand at cost, and debtors less any amount owing to third parties). The difference is known as goodwill. To the vendor this will represent compensation for the business’ reputation … the hard work the owner has put in getting the business to where it is today. To the buyer it represents a premium for the future earning capacity of the business. Goodwill represents the fact that the business can earn more money than a newly established business because it already has a customer base.
So, Value of Business = Net Tangible Assets + Goodwill
There are several methods of calculating goodwill. One that is commonly used relies on basing the value of the business on a required return on investment (ROI).
The main problem with the Asset Valuation Method is that it relies on past profitability and does not take into account the premium that might be justified for strong growth businesses or even a discount for those businesses that are in decline.
Discounted Cash Flow Analysis
A method that does take into account future cash flows is Discounted Cash Flow Analysis. The method is mainly used in feasibility studies, assessing whether an investment opportunity should be pursued or not, rather than as a business valuation tool.
Discounted Cash Flow Analysis is based on determining the present value of a business’ production opportunities or future cash flows. To compare cash flows from different points in time it is necessary to discount them to their present value … in other words, restating all future cash flows as if they were received today.
It is important to realise that ‘cash flows’ are not the same as ‘profits’ … they are flows of cash in and out of the business. Non-cash transactions (such as depreciation) may affect profit directly, but they only indirectly (through tax savings) affect cash flows. In addition, whilst the purchase of fixed assets does not directly affect profits, such expenditure is definitely a cash outflow.
Usually the most difficult aspect of using discounted cash flow analysis is to reliably determine future cash flows. It is advisable that you seek the advice and assistance of an appropriately qualified and experienced accountant to determine future cash flows and before using discounted cash flow analysis to value a business.