Business Value Acceleration
Business Valuation: Navigating the Complexity of SME Valuation Methods and Considerations
Valuing small privately owned businesses can be complex, as it often needs more readily available market data than large, publicly traded companies have.
Why do business owners need to know the business valuation?
Business valuation is not just about a number it is about identifying key value drivers, and risk factors and analysing the business model against perceived risk by benchmarking against businesses in the same industry (similar businesses). Business valuations will use financial data (past performance) and review business operations to determine future cash flows to determine a fair price – this is what a buyer, lender or investor will do.
Whichever valuation method is used measuring business assets helps an owner understand the value today, the value potential (future business valuation) and what they can do to move the needle.
What changes can you make to improve your business valuation?
To better understand the actions required to accelerate value it helps to understand business valuation. Considering not just financial reports but also looking at a strong market position, a loyal customer base, and a business’s reputation – this is the approach potential buyers will take (and their professional advisers).
Method to value small and medium-sized businesses
Business valuation methods include several standard approaches used to value small businesses, each with its own set of considerations:
Small and Medium-sized Enterprises (SMEs) require accurate valuation for finance professionals, considering their distinct characteristics and the need for careful assessment.
Asset-Based Approach
Net Asset Value (NAV): This method calculates the value of the business based on the difference between its assets and liabilities, as recorded on the balance sheet, and is a form of asset-based valuation. Evaluating business assets can be complex, as it involves determining which assets and liabilities should be included. This includes both tangible and intangible assets, such as property, machinery, intellectual property, customer goodwill, and a reputable brand.
Liquidation Value: This is similar to NAV but assumes assets are sold off, and liabilities are paid off, typically resulting in a lower valuation.
Income-Based Approach: Discounted Cash Flow Method
Discounted Cash Flow (DCF): This method, also known as the discounted cash flow method, estimates the value of a business based on its future cash flow projections, which are then discounted back to present value using a discount rate. This rate reflects the risk of the business.
The earnings multiple method is another approach where the business value is determined by multiplying the earnings before interest and tax (EBIT) with a specific ‘multiple’ to compare different businesses.
Capitalisation of Earnings: The business’s normalised historical earnings are divided by a capitalisation rate (similar to a discount rate), which is appropriate for the business’s risk profile.
Market-Based Approach
Comparables: The business value is estimated based on sales of similar businesses in the industry. This approach can be challenging for unique small businesses or areas with few comparable sales.
Financial data is crucial in this context, as it provides a concrete basis for comparison. Collecting financial statements, tax records, and cash flow statements helps in understanding historical financial performance and calculating valuation.
Rule of Thumb: Certain industries have rules of thumb based on metrics like sales, number of customers, etc. While not precise, it can provide a ballpark figure.
Combination Methods
Weighted Average: Some valuation processes combine the above valuation methods, such as ROI-based, asset valuation, entry cost, market multiple, discounted cash flow, and asset-based approach, to arrive at a more balanced valuation.
Key Considerations
- Business Type and Industry: The nature of the business and its industry can significantly impact its valuation. Some industries favour certain valuation methods over others.
- Financial Health: Analyzing financial statements for profitability, cash flow, debt, and revenue trends is crucial.
- Growth Potential: Assessing a business’s growth potential involves evaluating its ability to attract and retain customers, maintain healthy cash flow and revenue, and its potential for scalability. This is particularly important for valuing SMEs, considering their financial performance, assets, market position, and growth potential.
- Market Conditions: The current market environment, including the economic climate and industry-specific trends, can influence a business’s value.
- Intangible Assets: Brand value, intellectual property, customer relationships, and other intangibles can be crucial in a business’s valuation.
- Purpose of Valuation: The reason for the valuation (e.g., sale, partnership dissolution, financing) can affect the approach taken.
Challenges
- Lack of Marketability: Small, private businesses often face a discount in their valuation due to the lack of marketability compared to public companies.
- Owner Dependence: Many small businesses are closely tied to their owner’s skills and relationships, which can complicate valuation.
Given these complexities, small business owners often seek the expertise of professional business appraisers or financial advisors to obtain an accurate and fair valuation. These professionals can apply their knowledge to navigate the intricacies of the business’s financials, market position, and industry-specific factors.
Succession Plus has valued over 1,000 businesses in the last fifteen years and has used our Business Insights Report to evaluate business valuation – the valuation method we use is a weighted average maintainable earnings model with three years of historical data and one-year forward projection.
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