There are two reasons why you would value a business:
• Either you want to sell your business or you are thinking of acquiring another business
• Business owners should have an exit strategy. Valuing your business on a regular basis tells you how much value you are creating. It also indicates what needs to be done to make your business more competitive and hence more valuable.
How do I go about it?
Firstly, it should be noted that when buying and selling businesses, the actual price agreed will be based on negotiation between the two parties. Each party will have their own valuation and thus the actual value will be the price agreed.
Some points:
1. The more history a business has the more credible a valuation as it can be backed up by a track record
2. With small businesses (SMEs) one needs to build in additional risk. SMEs are vulnerable to market fluctuations and have high finance risk (e.g. a major customer doesn’t pay or banks reduce credit)
3. Circumstances can dictate the value. For example, selling to avoid insolvency will substantially decrease the valuation.
Types of Valuation
• Asset values: Investment houses, capital intensive industries and property companies are often valued based on their assets. An investment house, for example, owns stakes in various entities and it generates its income from these investments. Thus it is valued based on the worth of its investments.
• Price Earnings Ratio: This is the most common method and the valuation is determined by multiplying after-tax profit by the number of years a buyer is prepared to pay for these profits. An example best illustrates this. A business has profit after tax of R1 million. The valuer considers 7 years appropriate for your business. The value is thus R7 million.
o How do you determine the number of years? This is obtained from the Stock Exchange which is considered an efficient market. Currently the market trades on just below 22 years of earnings. This number is reduced for smaller entities as they are not as marketable as JSE shares and they carry much higher risk. In today’s market an SME with a good track record can expect to get between 5 to 7years of after-tax profits.
o Are adjustments made to after-tax profit? Adjustments should be made for one-off events (e.g. the sale of a large asset) and any other items which prevent making the after-tax profit a true reflection of the business’ profit.
• There are other methods of valuation such as discounted cash flow or entry cost (for new businesses).
Other factors
One would also need to consider other aspects when arriving at a value:
• How good is management?
• Do you have good relationships with major stakeholders?
• Is there effective governance?
• Are there some unique features in the business, for example dominant products in their markets?
These would be used to increase or decrease the number of years’ earnings to apply. For example, very strong management may convince the valuer to increase the figure from 7 years to 8 years, thus increasing the valuation.
Making use of valuations can be an important tool for your business.