Business valuation methods

Determining which valuation method to apply will require an assessment of the circumstances of the business.

By Kobus Oosthuizen    

The valuation of any business is a speculative affair, lending itself to a certain amount of guess work. If only we could look to a crystal ball for the answers, the business of business valuation will be more of a science and less of an art. Regardless of how hazy and unsure certain assumptions are, there are scientific principles which can be applied to at least make your guess an educated one.

The circumstances of the business play a significant role in determining the valuation method to be applied. Depending on the business, it may even be prudent to complete more than one valuation using a variety of methods and using the average of these results may also provide a measure of comfort.

Below we set out what we believe to be some of the more important circumstances that require your consideration in determining the most suitable valuation method to apply.

Maturity of the business

Most often, placing a value on a business relates to future performance expectations, and the probability of our future expectations being met is dictated by what occurred in the past. The longer the period for which information is available, the more accurately we are able to determine future trends.

As technological and consumer trends change rather rapidly, it is also warranted to assess the impact of such changes on the future potential of the business.

Size of the business

The size of a business most often refers to the period it has been in existence. However, depending on the type of business, it may also refer to its turnover, number of staff, investment in terms of setting up etc.

The impact the size of a business has on a business valuation relates to projected future trends. For example, it is unlikely that a large business with a large base will experience a steep growth curve. Big ships turn slowly and cannot easily swerve to avoid obstacles – ask our Italian captain. Small businesses however, especially if they are fairly fresh to the market, can justify more aggressive growth curves.

Type of business

While various hybrids exist, in principle, businesses accrue income either in a passive or in an active way.

Investment type or passive income businesses, and typically we are talking about real estate or share blocks in large listed companies, have a large tangible asset base that is fairly liquid in nature. This means they carry low risk and can be disposed of with relative ease. With steady income streams and low risk factors the valuation is pretty straightforward. It is always the subjective element of risk that makes valuations challenging.

Active businesses have less marketable assets and depending on the industry, these assets may be fixed or intangible. The valuation of these businesses is based more around the ability of the management team to produce income from the assets, rather than the actual value of the business itself. Small and franchised businesses fall within this definition.

Industry or sector within the economy

Businesses in all sectors of the economy are evaluated against predetermined sector benchmarks based on historical data, and while there are a myriad of benchmarks relating to various performance aspects, they are all worth considering when conducting a valuation. For example, what is a reasonable turnover expectation for a restaurant with a set-up cost of Rx, or what is a reasonable percentage of turnover to pay for rent?

Acceptable gross margins are also determined by the sector in which a business operates. Gross margins expected from a retail hardware store will differ from that of businesses operating in the Fast Moving Consumer Goods (FMCG) environment, which in turn differs from margins to be expected in a service orientated retail business.

Franchised or Independent business

There are a couple of assumptions which would be applied differently in a franchise environment than in the case of an independent business.

A franchise is a license granted to the operator to use the business system of the franchisor for a limited period, in exchange for a monthly royalty fee. Besides the cost effect of the royalty, a valuation cannot be done using a method that implies that the income would be earned into perpetuity.

On the other hand, the risk factor applied to a franchised business is likely to be lower than would be applied to an independent business of similar age.

Current profitability of the business

In evaluating a business as a going concern yielding a profit, it would be prudent to apply a valuation model based on future profits or cashflow. If however, the business is not generating cash, a different valuation method must be applied.

In such a case it would be more prudent to base the valuation on the replacement value of the assets, or even an assumption that the business is worth what the assets could be sold for on auction, less the liabilities that the business has at the time.

The considerations mentioned are not exhaustive, but are deemed to be the most important in deciding which valuation method to apply. In the next segment we examine the actual methods used and the impact of the above considerations.