When you’re considering selling, you’ll need to work out how much your company is worth, which can be challenging.
A subjective judgement, in other words, what you’d like it to be worth, or hope it will be worth, is insufficient. There are many different recognised ways to value your company objectively, but there’s also a lot of confusing and conflicting information on the internet about how to do it!
That’s why I’ve put together this article that discusses what a company’s valuation means, the factors that influence a valuation, and some of the more common methods of company valuation to help you get a better understanding of how to arrive at the right figure.
Let’s get stuck in…
What is a Company Valuation?
A company valuation is an objective assessment of the market worth of your business. It can be used when you are considering selling your company, merging with another company or seeking further investment in your business to help buyers, investors, and other stakeholders make informed decisions about your current situation and future prospects.
Factors That Influence a Company’s Value
As I mentioned, there are many ways to value a company and many factors that affect a valuation. Here are some of the most common factors affecting valuation:
1. Description of the company’s financial health (profits, cash flow, revenues)
A company’s valuation depends on how well the company is currently doing, as well as its future performance. A potential buyer or investor will want to understand the company’s history and how key performance indicators have been trending over time. Revenue, profit and cash flow are the most important vital signs for the health of a business, and these should all be moving in a positive direction if you are hoping to sell your business for maximum return.
2. Company’s assets and liabilities
To fully assess your company’s value, you need to work out the net assets, as this will factor in some of the valuation methods explained later on. Net assets include all your fixed and current assets, such as property, vehicles, equipment, trade debtors and cash at the bank.
Liabilities include long-term loans, short-term loans and credit cards, as well as your trade creditors and any bank overdrafts. To calculate your net assets, deduct your total liabilities from your total assets. Your net asset number is a snapshot taken at a chosen date of the net worth of your company.
3. Market conditions and the economy
The current prevailing conditions in the global, national and even local markets can affect your company’s valuation. When the economy is doing poorly, for example, in periods of very low growth or recession, there may be reduced demand for buying and selling or investing in businesses, especially those that are higher-risk, such as early-stage start-ups. This will drop the company’s valuation lower. When markets are buoyant, company valuations may be higher or even overpriced.
4. The company’s reputation and customer base
Your company’s valuation will be affected by how you are viewed in the market. Does your brand have a strong reputation and loyal customer base? A loyal and recurring customer base suggests predictable and consistent income flows, which will result in a higher valuation.
5. Potential for future growth and profitability
Investors and purchasers are attracted to companies where there is a high potential for growth and profitability. A plan for future growth coupled with evidence of high historical growth will push your company valuation up.
6. Market size and competitors
The larger the market size, the bigger the potential for your company and consequently, this can push up a valuation. If you operate in a highly competitive market, this is likely to adversely impact your valuation. However, if you are in a large market with fewer competitors, your valuation will likely be higher than a comparable company in a smaller market with more competitors.
7. People
Your company’s valuation is likely to be affected by the management structure and the talent you have in place. Companies with a strong management team and motivated staff will contribute to a higher valuation than if you are a sole owner with limited resources and no one to delegate to.
Methods of Company Valuation
Company valuations can be tricky because there are multiple ways to do it. This can make it difficult to make comparisons between different opportunities. These are some of the more common ways you could value your company.
Book Value
The Book Value, sometimes also known as Net Book Value, or Asset-Based Valuation of a company is calculated as the total assets less the total liabilities. It is sometimes expressed as Book Value Per Share (BVPS), which can help potential investors or buyers to make comparisons with other companies of different sizes. This calculation can be complicated if there are significant intangible assets to value.
Entry cost
This valuation method reflects the cost of setting up the business from scratch. It includes all the costs of purchasing assets, staff recruitment and training, building a customer base, product development etc., to arrive at a starting valuation.
Times Revenue Method
This method of valuation applies a multiple to the current revenue to arrive at a valuation. The multiple is determined by industry and economic factors. Typically the multiple is between 1-2, though it could be as high as 3-4. Sometimes the multiple is lower than 1.
Liquidation Value
The Liquidation Value is the amount that could be generated by selling off all the company’s assets. This is sometimes used as the lowest value that a business might be worth to determine the floor in a range of possible valuations.
Discounted Cash Flow
This method of valuation takes into account the time value of money, in other words, it incorporates the impact of devaluation of currency due to price inflation. Discounted cash flow (DCF) estimates the value of an investment using its expected future cash flows discounted to their current value. If the DCF is higher than the current cost of the investment, this may be a good opportunity. If DCF is lower, this may not be a good opportunity or it may be that more analysis is required to make an informed decision.
Capitalisation of Cash Flow
The Capitalisation of Cash Flow method of valuation values a company based on expected cash flows capitalised using a risk-adjusted rate of return. This is a more complex valuation method requiring a few steps:
- Determine the average post-tax net income, also known as Free Cash Flow (FCF), for the next 12 months
- Divide this by the capitalisation rate (which can be calculated as Weighted Average Cost of Capital – the sustainable growth rate per annum)
Price/Earnings Ratio
The price-to-earnings ratio (P/E) is the relationship between a company’s stock price and its earnings per share. Earnings per share are usually calculated as earnings for the past 12 months divided by the weighted average number of shares. Companies that aren’t listed on a stock exchange will often have a P/E ratio around 50% lower than a comparable quoted company, as these are seen as riskier investments.
Challenges and Pitfalls in Company Valuation
As you can see, there are many ways to calculate the value of a company. Using incorrect data or an inappropriate valuation method can lead to issues with decision-making, resulting in expensive mistakes.
Common mistakes made in company valuation
There are a few mistakes that it’s all too easy to make when valuing a company if you aren’t careful with the data you are using.
Simple maths errors
Check all calculations for any mathematical errors as this sort of problem is more common than you might imagine.
Not using the correct multiple
When using the Revenue times method, the correct multiple will be determined by reviewing comparable sales of similar businesses in your industry. However, the data should be analysed to ensure that there are no outliers such as businesses sold for abnormally high or low multiples, businesses sold more cheaply, for example to family members or other anomalies that could skew the data.
Not using the right earnings
There are different ways to calculate earnings – EBITDA, SDE, Net Income, Cash flow etc.). The most commonly used is EBITDA, but this can overvalue a small company, so choosing the correct earnings calculation is important when valuing a company.
A good rule of thumb is to use EBITDA for a company with earnings over AUD $2m, use SDE for a company with earnings below AUD$1.5m and for those companies with earnings between AUD$1.5-$2m, use SDE for an individual buyer and EBITDA for a strategic buyer or private equity investor.
Using the wrong valuation approach for the company size
Some of the valuation methods, such as Asset-based valuation or DCF may be unsuitable for smaller companies because they can result in undervaluation.
Basing the valuation on future performance rather than historical performance
Many business owners will want to value their business based on potential earnings rather than past results, especially if high growth is expected. However, buyers tend to want a valuation based on the average results from the past 2-3 years.
Using cash basis accounting statements rather than accruals basis
When calculating a company valuation, it’s vital to use statements made up using accruals basis accounting which include amounts committed as well as amounts received and paid out in the period in question.
Implications of inaccurate valuations
If your business valuation is incorrect, this could lead to problems with investors or buyers. If your valuation is too low, this could attract the wrong kinds of investors or could impact your ability to raise future funds.
If your valuation is too high, it may be harder to find a buyer or investors and could send the wrong signals about your long-term business strategy.
Getting the right valuation is, therefore, vitally important for securing the right buyer or investor for your business, and this is where you’ll benefit from professional support and experience in the art and science of business valuations. Contact me at 0448 000 010, message me on LinkedIn or email me at eddie@eddiesentore.com
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