The methods of business valuation
Unlike most other assets and commodities, the value of a small business is not dictated by what the market offers, but rather by the ability of its intangible assets to generate wealth.
In our last segment in this series we dealt with the factors and circumstances that impact the decision of which valuation method should be applied to a specific business. We now take a closer look at the actual valuation methods available and the circumstances under which they should be applied.
By Kobus Oosthuizen
The price-earnings method
The prince-earnings method is a widely accepted method of valuation for small to larger businesses and employs projected future profitability as the basis of the valuation. In other words, what the buyer is actually buying is the future profits of the business. The science in this method of valuation is to determine the likelihood of the projected profits actually being realised.
The price-earnings ratio or PE, is a multiple which is applied to the quantum of projected future profit, and the decision which multiple to use is the subjective aspect of the valuation.
The higher the perceived future risk or the lower the growth potential of the business, the lower the multiplier used. If the business has good potential and is operating in a sector where risk is lower, the multiplier will be higher.
In order for this method to be applied, the business must be making a current profit and needs to have been in existence for at least three years to allow for a parallel to be drawn between past performance and future growth.
Discounted cashflow methods
This valuation model is applied when the quantum of future cashflows can be determined fairly accurately. Asset based businesses with certain income streams such as fixed rental income over medium term periods, is a prime example of a business where this method can be applied. Due to the erratic nature of future profitability and cashflow, as experienced by most small businesses, this method is not commonly applied to small business valuations.
This method is based on the adding up of income streams after they have been adjusted for the time value of cash. On the assumption that the cost of capital is ten percent per annum, R1 received today would equate to R1,10 in a year’s time and R1,21 in two year’s time.
Asset value method
This valuation method largely ignores the impact the operator may have on a business, basing the valuation on the cost price or replacement value of the assets of a business instead. Newly established businesses, with no or very little trading history, would be valued in this manner.
Any new business has a threshold in terms of profitability, from where the valuation is dictated by the goodwill of the business rather than the inherent value of the assets. A new business with new assets will be valued at the set-up cost, but it is assumed that such a business will be generating a profit in the near future, and it is at this point that a price-earnings method will be applied rather than the asset value method.
Forced sale value
When a business is in a position where it is not generating cashflow, in other words where the owner has to fund the cash shortfall on a regular basis, then none of the above mentioned valuation methods will apply. In such instances the business is not deemed a going concern and the owner should give serious consideration to closing the business, unless a prospect exists in the near future that will justify continued operations.
With the assumption that no meaningful prospect exists to support continuing the business, the value of the business would be deemed to be the open market value of the assets, less the value of existing liabilities and any liabilities accrued as a result of the closure of the business. It is very likely that certain current liabilities would have accrued as a result of the cashflow pressures experienced and in addition to these current liabilities, contractual liabilities may have accrued towards parties such as personnel and the landlord, as a result of closing down the business. Often the value of the assets is less than the value of liabilities, and the owner, depending on his legal status in relation to the debt of the business, may be required to stand in for the shortfall.
The valuation achieved by applying a particular valuation method may imply that another method of valuation would be more suitable. If, for example, the result yielded by applying the price-earnings valuation method calculates the value of the business at a lower value than the actual market value of the assets of the business, then the price-earnings valuation should be ignored and the asset value method should be applied instead.
Business valuations involve the assessment of many "soft" issues and as such are never absolute or scientific. The experience of the valuer in generic and industry specific businesses, for example, plays as an important role as the purpose of the valuation.
One golden rule applies however, and that is to compile proof in support of your assumptions. Circumstance may and probably will change post any valuation, which may cause a valuation to be challenged, and for that reason the assumptions at the time of the valuation should be accurately and comprehensively documented.
SA Franchise Warehouse
http://www.safw.co.za/
In our last segment in this series we dealt with the factors and circumstances that impact the decision of which valuation method should be applied to a specific business. We now take a closer look at the actual valuation methods available and the circumstances under which they should be applied.
By Kobus Oosthuizen
The price-earnings method
The prince-earnings method is a widely accepted method of valuation for small to larger businesses and employs projected future profitability as the basis of the valuation. In other words, what the buyer is actually buying is the future profits of the business. The science in this method of valuation is to determine the likelihood of the projected profits actually being realised.
The price-earnings ratio or PE, is a multiple which is applied to the quantum of projected future profit, and the decision which multiple to use is the subjective aspect of the valuation.
The higher the perceived future risk or the lower the growth potential of the business, the lower the multiplier used. If the business has good potential and is operating in a sector where risk is lower, the multiplier will be higher.
In order for this method to be applied, the business must be making a current profit and needs to have been in existence for at least three years to allow for a parallel to be drawn between past performance and future growth.
Discounted cashflow methods
This valuation model is applied when the quantum of future cashflows can be determined fairly accurately. Asset based businesses with certain income streams such as fixed rental income over medium term periods, is a prime example of a business where this method can be applied. Due to the erratic nature of future profitability and cashflow, as experienced by most small businesses, this method is not commonly applied to small business valuations.
This method is based on the adding up of income streams after they have been adjusted for the time value of cash. On the assumption that the cost of capital is ten percent per annum, R1 received today would equate to R1,10 in a year’s time and R1,21 in two year’s time.
Asset value method
This valuation method largely ignores the impact the operator may have on a business, basing the valuation on the cost price or replacement value of the assets of a business instead. Newly established businesses, with no or very little trading history, would be valued in this manner.
Any new business has a threshold in terms of profitability, from where the valuation is dictated by the goodwill of the business rather than the inherent value of the assets. A new business with new assets will be valued at the set-up cost, but it is assumed that such a business will be generating a profit in the near future, and it is at this point that a price-earnings method will be applied rather than the asset value method.
Forced sale value
When a business is in a position where it is not generating cashflow, in other words where the owner has to fund the cash shortfall on a regular basis, then none of the above mentioned valuation methods will apply. In such instances the business is not deemed a going concern and the owner should give serious consideration to closing the business, unless a prospect exists in the near future that will justify continued operations.
With the assumption that no meaningful prospect exists to support continuing the business, the value of the business would be deemed to be the open market value of the assets, less the value of existing liabilities and any liabilities accrued as a result of the closure of the business. It is very likely that certain current liabilities would have accrued as a result of the cashflow pressures experienced and in addition to these current liabilities, contractual liabilities may have accrued towards parties such as personnel and the landlord, as a result of closing down the business. Often the value of the assets is less than the value of liabilities, and the owner, depending on his legal status in relation to the debt of the business, may be required to stand in for the shortfall.
The valuation achieved by applying a particular valuation method may imply that another method of valuation would be more suitable. If, for example, the result yielded by applying the price-earnings valuation method calculates the value of the business at a lower value than the actual market value of the assets of the business, then the price-earnings valuation should be ignored and the asset value method should be applied instead.
Business valuations involve the assessment of many "soft" issues and as such are never absolute or scientific. The experience of the valuer in generic and industry specific businesses, for example, plays as an important role as the purpose of the valuation.
One golden rule applies however, and that is to compile proof in support of your assumptions. Circumstance may and probably will change post any valuation, which may cause a valuation to be challenged, and for that reason the assumptions at the time of the valuation should be accurately and comprehensively documented.
SA Franchise Warehouse
http://www.safw.co.za/
Thank you for sharing this article with us Nelson. I came across your article while I was online looking up Business Valuation in NYC for my small business. Your article has provided some insight that I did not know and was very interesting. Thank you again for sharing, I'm going to make sure to subscribe to your blog.
ReplyDeleteThank you for your comment Mike. I am glad you found value in the article. Please note that I will be posting more articles focused on Business Valuation. I hope you continue to draw value form our blog.
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