Business valuation: Knowing your business’s worth

In this article, we aim to outline the essentials of a business valuation.

Why business valuation matters

Firstly, let’s address why knowing your business’s value is important.

Understanding your business’s value is more than a number on a balance sheet. If you understand what your business is worth, it can help with your decision making when considering a potential sale, seeking investment or strategic planning.

By planning ahead, as a business owner, you may be able to realise an increased price if part of your strategic focus is on maximising the business’s value.

Potential investors and lenders will make use of a business valuation to gauge their risk and potential investment return when purchasing your business.

For companies that offer shares to their employees, a valuation is also important. Employees will want to clearly understand what their shares are worth. This transparency can strengthen alignment between a business’s objectives and employee efforts, enhancing productivity and motivation. It also aids in employee recruitment and retention, providing a competitive edge by attracting top talent who see the potential for growth and financial reward.

Common approaches of business valuation

Common approaches to a business valuation are the asset-based, earning value and revenue / EBITDA methods.

Asset-based approach

This method calculates your business’s worth based on its balance sheet. It is straightforward and practical for businesses where the value is reflected in its assets (such as a property company) rather than in its revenue streams. The asset-based approach is also useful for determining a notional break-up value of a business.

However, the asset-based approach can fail to reflect the full potential of future earnings, particularly for businesses in rapidly growing industries or those with significant intangible assets such as brand loyalty, customer relationships or proprietary technology.

Earning-value approach

Often considered the most reflective of a business’s value, this method focuses on earning potential. The earning-value approach, particularly through the discounted cashflow (DCF) method, forecasts future cashflows and discounts them back to their present value.

The earning-value approach is appropriate in situations where future operations are important in determining a business’s value. Start-ups and high-growth businesses where past financial results may not indicate future earning potential are examples of where this approach may be appropriate.

The earning-value approach does come with significant challenges. It is heavily dependent on the accuracy of forecasting, making it susceptible to errors due to overly optimistic assumptions or unforeseen changes in the environment in which it operates. This method also requires a good understanding of financial modelling, which can be a barrier for businesses without access to these skills.

Revenue and EBITDA multiples

A straightforward and commonly used method involves applying industry average multiples to current revenue or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) results. This method is particularly prevalent in industries where benchmark multiples are well-established, providing a quick and less subjective means of valuation compared to methods like the DCF.

This method is of particular use where past revenue or EBITDA results provide a good indication of future earnings.

However, it is important to note that while this method is easier to apply and less speculative, it does not account for the future growth potential or downturns of the business, which might be captured in other methods like the earning-value approach.

Key drivers affecting business value

Several factors influence a businesses value. Market conditions, industry performance, customer diversity, brand strength, financial health, revenue trends and profitability being examples of these factors. Regulatory environments and legal considerations can also significantly impact a business’s valuation, as changes in government policies or compliance requirements can impact operational costs.

The quality of management and the workforce’s skill level are key, as these can drive a business’s strategic direction and operational efficiency.

Intellectual property, such as patents and trademarks, further contribute by providing competitive edges and securing long-term revenue streams.

Practical steps to determine your business’s worth

To start valuing your business, you can follow these practical steps.

• Gather financial statements: you may need at least three to five years of historical financial statements, including profit-and-loss statements, balance sheets and cashflow statements.
• Forecast future earnings: use your financial data to project future earnings. Consider market trends and how changes in your business model could affect these projections.
• Choose the right valuation method: choose the most appropriate valuation method or combination of methods depending on your business type.
• Consider seeking professional advice: valuing a business can be complex and professional valuers can provide expertise and insight.
• Benchmark against other businesses in the industry: Comparing your business to similar businesses within your industry can provide additional support for your valuation. Benchmarking can highlight competitive advantages or challenges and help validate the assumptions made during your own valuation process.

Common pitfalls in business valuation

Avoid common mistakes such as:

• Overemphasising historical financial performance without considering future potential.
• Placing reliance on one method of valuation when a combination of methods might indicate a more accurate position.
• Ignoring the non-financial factors like market conditions, quality of management etc.

Wrapping up

Knowing your business’s worth is a powerful tool. Whether planning to sell, seeking funding or simply looking to understand your business better, a well-grounded valuation can help to make informed strategic decisions and drive business success.

To find out more about our strategic planning services visit our webpage.

Please contact 023 8046 1240 or email Gary Brown if you would like more information on the above.