What is it worth? Whether you're buying or selling, this is the million dollar question-as well as the sticking point for many in an M&A negotiation. Many times the seller won't provide a starting price, which means it's up to you to figure out the initial offering. As a seller, without a clear idea of how much your company is worth you can encounter two problems: under-estimating your company's value, which throws away your hard work and leaves cash on the table or overestimating the value of your business, which can lead to no buyers and maybe, no sale. This is why companies undergo professional valuations.
Introduction to Valuations
Valuation is the process of determining the current worth of an asset or company, usually performed by a third party analyst such as a business broker or certified business appraiser. However valuation is more complicated than just adding together price tags, including both the value of physical assets such as equipment and inventory and more intangibles such as staff, brand recognition, intellectual property , customer & client lists, phone numbers, URL's and projected future earnings. This article will go over the most commonly used types of business valuations, and when these types of valuations provide a better understanding than kinds of valuation of the business they are assessing.
Fixed assets are things like property, equipment, and capital assets, all of which have solid values if sold directly on the market. Companies that are based off these assets, such as retail (which is mostly location and inventory) and manufacturing (which is mostly equipment and inventory) work best with this kind of approach. Asset valuation is determined by the following:
- Fair Market Value of Fixed Assets: the open-market price of these assets if you were to purchase them.
- Leasehold Improvements: changes made to the property that would be considered part of the real estate were you to sell or not renew a lease.
- Owner Benefit: determining the discretionary cash gained by the seller in one year, determined by their adjusted income statement.
- Inventory: the wholesale value of the company's inventory, including raw materials, work in process, finished goods and products.
Capitalization of Income Valuation
But what if your company doesn't have a lot of fixed assets and inventory, such as a service company? Capitalization of income valuations don't place value on these fixed assets, and instead focuses on current cash flow to predict future earnings. Factors that are used include:
- Annual Cash Flow: how much the company generates in a year in total gross sales. This value uses the company's last fiscal year or trailing twelve months as a basis.
- Expected Annual Growth: if the company has a positive growth, how much growth is expected every year?
- Risk: every company has a certain amount of risk. Factoring in all factors of risk, including customer base, competition, location, and a myriad of other risk factors creates this value.
Expected annual growth and risk are used to create the "Cap Rate" against which the cash flow is divided. This provides a projected future earnings number for potential buyers.
Market Approach Valuation
Commonly used in real estate, the market approach determines the value of a company by comparing it to what similar companies have sold for. This approach doesn't just look at price tags, but dives deep into the companies that have sold to break down the sale by values of the business. This process, using as an industry average multiplier or "industry multiplier," is a way of determining the price of a company by multiply its values against a standard. There are now numerous data bases available to valuation professionals to source this data. Some examples:
- Family Retail: annual sales times one third or 1-2 times annual profit.
- General Service Companies: annual net profit, inventory, and equipment times 1.7.
- Job Shop Manufacturing: EBITDA plus work in progress times 3-5. If the shop has patents or proprietary processes, instead multiply the EBITDA value by 4-6.
That's it for part one! In part two we'll cover four other kinds of valuations, including Owner Benefit Valuations and the Discounted Future Earning Approach. If you're interested in getting your business or a potential buy valuated, please contact George & Company. We've got the experience and the information to make the right valuation for your company.