What Is Your Business Worth? And Why It Matters
Building a business can be a long, challenging process. One way to assess how you are doing is to VALUE your business… and then try to grow that valuation. This keeps management on track and is interesting to sellers, investors or lenders. In this article, we look at how to go about valuing your business.
Would you participate in sports… but not keep the score? Perhaps. For example, you might enjoy hitting tennis balls with a partner, honing your technique, enjoying the outdoors and working up a sweat. But the score helps track how we are doing relative to our opponent, our last performance, the professionals, and relative to the course itself (in the case of golf). The score also tells us who wins!
Businesses have scorecards. Revenue, profit and growth-rates are examples but the valuation of a business is one of the most important metrics. Here are some pointers on valuing your business.
Get your business affairs in order
Valuation involves looking at the state of your finances. Up-to-date financial statements are needed to describe recent business performance, value your assets and identify any debt.
Ensure your legal affairs are also up to date. Which entity exactly is being valued? Is there just one entity or is it part of a group? Are the entities properly registered, licensed and compliant? Is ownership clear?
What valuation method makes sense?
What buyers have paid for a business similar to yours is a good indicator of value. No company will be identical to yours and it may be difficult to get accurate information, especially for private sales.
In that case, the market capitalization of listed companies (whose financial information is publicly available) can provide guidance IF they are substantially similar in terms of business model, the market they serve, size and other factors.
Consider Industry Valuation ‘Norms’
Certain industries (or business models) prefer certain valuation methods. For example, manufacturers rely heavily on net asset valuation (such as property, plant and equipment) to determine business value. Some service industries value businesses based on a multiple of annual revenue. Understand what methods have been applied in your industry and consider whether they apply in your case.
Consider Return on Investment (ROI)
You can value your business based on net profit and the ROI you want to achieve. For example, say:
- Your net profit for the past year was $200,000
- You want an ROI of at least 60% for the sale of your business
- Apply the formula: Value (selling price) = (net annual profit/ROI) x 100
- In this case: Business Value = (200,000/60) x 100 = $333,333
So, to achieve an ROI of 60%, you’ll need to persuade someone to pay at least $333,333.
Consider the (net) value of your assets
Value your tangible assets (physical things like plant, equipment, and property) and intangible assets (like goodwill, brands and intellectual property). Goodwill can include customer relationships, business reputation and operating procedures. You’ll need to take into account depreciation because your assets will lose value over time. Deduct the value of any liabilities to arrive at a net asset valuation.
Consider the cost of recreating your business
Imagine if you were to start over from scratch. You’d have to register your business, buy stock, equipment, and tools, obtain licenses, hire and train staff, make your products, market your products, lease or buy premises and build a reputation with customers, vendors and the broader community.
This would cost money and also take time, in some cases, years. Part of the current value of your business is that you are saving a buyer from having to spend the time developing the business.
Consider the value of future profits
Value is based on your CURRENT and PAST performance but, FUTURE potential will be even more critical to certain investors. You’ll need to develop forecasts covering these questions in some detail:
- The Market: In which market does your business compete? Are there many (well-established) competitors? Who are the customers? What are the trends in the market? Is it growing? Is regulation increasing?
- Products / Services: What exactly will you sell into this market? How will you produce it? At what cost? Why does the market need YOUR product?
- Team: Who is driving the business? How are they qualified to perform their roles? Why are they likely to succeed?
- Sales Forecasts: How much will you sell? At what price? Why will customers buy YOUR product? These are your revenue forecasts.
- Expense Forecasts: What will it cost you to run your business? Consider costs of goods sold and operating expenses.
With the above information (the more detail the better), you can forecast how much income your business will generate relative to the money spent – a very strong indicator of valuation.
There is no single way to value a business. The best indicator of value is determining what an actual buyer is willing to pay. Valuation is market-driven, not simply a matter of applying a valuation methodology. But these methodologies help the negotiating parties to make a convincing case on value and get the outcomes they want.