How Much Is This Business Worth?
How Much Is This Business Worth?
When the time comes to buy a business in Australia, it ultimately comes down to one question.
“How much is this business worth?”
The difficulty in answering this question is compounded when both the seller and buyer may have differing views as to the value of the business.
And indeed, there are many ways to value a business.
So where do you start and how can you come-up with a value that allows you to move forward?
In this article, we’ll explore the most common methods for valuing a business, what circumstances they are used in and arguably the most useful method for a small business.
Main Methods Used To Find Out How Much A Business Is Worth
Most valuation methods are based on the assumption that the business is generating profits.
If so, then projecting those profits and cashflows into the future plays an important part in determining how much the business is worth.
Let’s look at the most common methodologies
Discounted Cash Flow Method
Under this method, the business’ future cashflows are projected and then discounted to a present-day value, using an appropriate discount rate.
It’s very common to use this method for larger businesses, where the level and sophistication of future data is readily-available.
Generally used for businesses valued at $5m or above.
Capitalisation of Maintainable Earnings
For this method, a business’ past performance is used to project a level of maintainable earnings into the future.
From there, an appropriate multiple is applied to provide an expected value.
So if a business was projected to have future annual maintainable earnings of $100,000 and a multiple of 3, then the value of the business would be $300,000.
Whilst significant consideration of the maintainable earnings and the multiple used is required, it allows for a lower level of data quality and sophistication than the Discounted Cashflow Method.
Many SME businesses use this method to work out how much a business is worth.
This method is used when the business is not generating any meaningful profit or operating on a distressed basis.
Someone may still wish to purchase the business as they may believe the business may become profitable by incorporating it into another business.
Or the business has simply closed down and all assets and liabilities are being realised.
In this case, the value of the business is simply the value of its assets less the value of its liabilities.
This is a common valuation method whereby a multiple is applied to top-line revenue in order to derive a business valuation of sorts.
So if a business generated $2m in revenue and the industry multiple was $1.50 for each $ of revenue generated, then the value would be $3m.
Whilst this is a common method, it generally favours the seller and the buyer should be aware of its flaws.
Best Method To Find Out How Much This Business Is Worth for SMEs?
The reality is, there is no one best method to determine the value of an SME business in Australia.
The nuances of each business are such that sometimes a combination of valuation methods is required to find out how much it’s worth.
But the Capitalisation of Future Maintainable Earnings method generally allows businesses to be valued based on existing information that will most likely already be held.
From a seller’s perspective, they can extract information from their existing accounting system to allow this methodology to be undertaken.
From the buyer’s perspective, it allows them to determine whether return on investment (“ROI”) is sufficient for the risk they are taking on.
- A multiple of 2 = 50% ROI
- A multiple of 3 = 33% ROI
- A multiple of 4 = 25% ROI
So why not consider another valuation method solely?
A discounted cash flow analysis generally requires information that most SME businesses do not maintain.
Projecting cashflows for the next year (especially with the impact of COVID) is difficult enough, let alone over the next 5 to 10 years.
An asset-based approach would not account for any Goodwill associated with a profitable business.
And the benchmark approach by itself can provide misleading results, as it doesn’t account for any efficiencies/inefficiencies in how the business is being operated.
The Capitalisation of Maintainable Earnings approach provides a balance between information that should already be available and a basis for allowing some form of future projections and risk assessment to occur.
For most SME businesses in Australia, there are a number of ways to determine the answer to the question “How much is this business worth?”
But the reality is that only one or possibly two valuation methods will be applicable.
Even once a business value has been determined, the seller and buyer may still find themselves involved in extensive negotiation regarding their perception of the true worth of the business and even whether you should buy the assets or shares.
Business, more than anywhere else, truly captures the saying, “value is in the eye of the beholder”.
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