VALUATION vs PRICE - What is business really worth?

If valuation does not equal purchase price, what is a business really worth?

By Bob Power

On the subject of business valuation it is important to remember that there is no standard method for valuing a business and no single ‘correct’ answer as to how much a business is worth. A mentor of mine once said “There is no correct method for valuing a business; due diligence, negotiation experience, judgement, ‘business nose’ and horse-trading skills all have an important impact on the final outcome.” I also once attended a business seminar where 15 of us were each given a set of financials and instructed to valuate the business. The result was 15 different valuations based on the same set of financials.

There are, however, criteria common to all business enterprises which enable basic valuation rules to be formulated.

Whether buying or selling, I have rarely concluded a deal on the value calculated by an auditor or adviser. Any valuation is no more than a guideline and the price eventually paid may differ significantly.

Regardless of the method used to establish ‘reasonable value’, one principle holds true; that the value of the business assets is the sum of its expected or potential earning power and the degree of risk or uncertainty involved. The ultimate value of a business depends on its profitability and its ability to expand that profitability. The real value of a going concern in a purchase/sale transaction lies in its future earnings rather than its past earnings. Investors and other interested parties are attracted to enterprises with a stable cash flow history and good prospects for future earnings.

Factors that influence the price and valuation of a business:

• The worth of a business is a function of its profit potential, balanced by the investment required and the risks involved.
• Past profitability and asset values are a good start, but other factors such as supplier relationships and intangible aspects such as intellectual property, reputation, branding, goodwill, name and location can affect the value.
• It is usually accepted that any price is right as long as the business can pay for itself over a reasonable period of time, usually two years. For a business with a profit of R200,000 per annum,  R400,000 would then be considered reasonable.
• A due diligence investigation may unearth reasons to support a reduced price. If serious problems are discovered it becomes a fire sale transaction where the business, if it is worth buying at all, is sold at the value of the assets less liabilities.
• The owner’s/seller’s drawings must be taken out of the valuation, because if it is too high it creates a false impression of the business value.
• The valuation may not be realistic under reigning market conditions. In a market of strong competition, there are no guarantees of future success.
• Placing a value on a business much depends upon the bargaining position and negotiating skills of the parties.
• If there are sound synergistic possibilities, a premium may well be paid over and above the calculated value, sometimes called goodwill.
• The valuation exercise may be quite straightforward, but is influenced by assumptions and variables such as future profits, returns, market conditions, existing management and financial structures.
• If the seller’s lowest price is close to the buyer’s highest price there is usually a deal.
• Relying on the financial statements alone is not advisable as there may be discrepancies between the asset value reflected in the balance sheet and the actual market value thereof.
• Because the business is their baby, sellers want to be paid for all the hard work and goodwill generated, which is often not practical.
• The best known methods of valuation are often not realistic for small businesses.
• Any business is only a good investment if it can earn a good return on the price paid.

In conclusion it is perhaps safe to say that while price is what the buyer eventually pays for the business, value equates to how desirable or important the business is to the buyer. All discussions about value and price aside, never buy a business unless you are certain that the business is right for you.


Power Corporate Consulting
www.powerconsulting.co.za
rpower@mweb.co.za
+27 11 880 7850