Five Key Questions To Answer When Valuing A Business
- What does the valuation include or exclude?
- How do you calculate the value of a business?
- What information do you need to get the most appropriate answer?
Most people think the value of a business is some magic number times the profit of the business – and it in some case that is correct. But not everyone understands what is involved in determining the magic number or what is included in the profit figure and what should be excluded.
There are regular myths and mistakes that we have come across, including:
- Using a rule of thumb (such as value = 110% of revenue) as a primary valuation method.
- Using a multiple that is inconsistent with the profit figure being used.
- Adding asset value to the valuation that comes from the earnings multiple method.
- Not treating increased working capital requirements from future growth appropriately.
- Using an inappropriate method of valuation (using an income approach when the cost approach is more appropriate).
- Being inconsistent with metrics when comparing other business transactions.
- Over-estimating future growth of the business.
- Over-estimating the earnings multiple
- Using an historical multiple with future cash flow projections.
- Failing to account for market wages of the owners.
- Capitalising cash flows without appropriate treatment of property assets.
Each of these myths and mistakes can have a big impact on any final decisions, such as:
- Selling a business below market value.
- Unrealistic expectations that fail to support an agreement between parties, and therefore failing to resolve a dispute.
- Paying too much for a business.
- Paying too much tax for as a result of a business transaction.
- Not paying enough tax only to find you are also paying a penalty.
A business valuation is not simply “running the numbers”. It starts with the basis of why the valuation is needed, developing an hypothesis about the valuation and then identifying the key questions that need to be answered to arrive at a consistent and defendable valuation.
Any valuation needs to answer five key questions in order to arrive at a business valuation that is consistent, reliable and defendable:
- What is the primary purpose of the valuation? What is at risk?
- What is being valued – the enterprise or the equity of the entity?
- What is the appropriate standard of value – market value, strategic value or some other standard?
- What is the most appropriate method of calculating the value of a business? Do you use an income, market or cost approach?
- What evidence is required to support the outcomes of a valuation analysis?
It is only after answering these questions clearly that the valuation expert can start to consider “running the numbers” or collecting data. It is worth noting that it is not until question four that any serious thought is given to an earnings multiple or profit figure. And in some cases neither of these figures may be relevant.
We have tried to give some more detailed answers to some of these questions in our FAQ page and this link provides an overview of our valuation process.
We have also written a whitepaper that addresses all of the these questions, and more in 10 SMART Valuation Lessons You Must Know.
And check our website soon for a more detailed outline of valuation methodologies and a basic valuation calculator.
So when you start thinking about the value of your business, make sure you have the right answers to the right questions before making important decisions.