How To Value A Business?
How to value a business?
Business valuation is a process or technique used to assess a business or entity’s financial or economic value accurately. It can be used to determine the fair value of a business for various reasons, i.e. sale, merger or deal value, establishing partner ownership, or taxation. Investors or business owners generally turn to a professional business valuation consultant for an objective estimate of the value of the specified business.
Objectives of valuing your business:
The main objective of evaluating a business value is to identify the critical value-generating areas of the business. Let us analyse the various key objectives defining how do you value a business, as follows:
- Introduce a partner (and role of partner):
Every partnership is unique, and hence the business valuation must factor in the needs of all parties involved. The partners should agree on the type of business valuation, which will prove beneficial in any legal disputes or buyouts later on. Business valuation when a partner is introduced (and the role of the partner) consists of estimating the:
- Book Value – which is the easiest way to value a business. …
- Multiple Sales or Profits – An effective way to value a business not having too many assets or a large balance sheet. …
- Market Comp Approach – In this approach, private companies are compared to similar public companies.
- Introduce funds via investors
During the seed funding round, a startup investor pumps in funds to share the company’s equity. This is why business valuation is important for entrepreneurs as it helps in estimating the equity offered to a seed investor in exchange for funds. For the investor, it is also essential to know how much of the company’s share they will receive in lieu of their funds invested during the seed stage. Therefore, startup business valuation can prove to be a real deal maker or breaker, which is why valuation does not involve any guesswork based on the valuation of similar start-ups.
- Sale of business (part sale or complete exit)
Valuation of a business for sales (part sale or complete exit) can be termed as the fair market valuation of a company. This is calculated as the fair value of the business assets minus the external liabilities owed. The key here is determining fair asset value, which may differ significantly from acquisition value (for non-depreciating assets) and recorded value (for depreciating assets). There are several ways to determine the market value of your business for sale, i.e.
- Tallying the asset values: This consists of all assets, including equipment and inventory.
- Basing it on revenue
- Using earnings multiples
- Doing a discounted cash-flow analysis
- Going beyond financial formulas
- Other Purposes
Other purposes or objectives for business valuation can be enumerated as under:
- Litigation: During any court case, one may need to provide proof of the company’s value so that they are based on the actual estimated business worth in case of any damages.
- Exit strategy planning: An annually updated valuation with annual updates will keep the business ready for unexpected and expected sales, also ensuring a fair company market valuation.
- Buying a business: A good business valuation will analyse prevailing market conditions, potential income, and other similar factors to ensure that the investment being made is viable.
- Strategic planning for good decision making: A current business valuation provides important information that enables better decision making and strategic planning.
SWOT Analysis – To understand the opportunities and threats for the objective to be achieved
SWOT (Strengths, Weakness, Opportunities, Threats) analysis is a strategic planning technique that helps to evaluate the business value. It is useful for a business when looking for a partnership, investor funding, or evaluating business deals and mergers. To understand business opportunities, the following external positive factors have to be considered:
- Lack of competition
- A niche market that is not being serviced in your target customer region
- A new product or service that complements your current product portfolio and facilitates up-selling and cross-selling
- Efficiencies through better technology adoption and plant modernisation
- Providing better, quicker service at a competitive price compared to a rival
- Market or environmental opportunities we benefit from
- Positive business perception
- Recent market growth or disruptions creating an opportunity
With regard to threats, the following external negative components can be identified:
- Existing or potential competitors moving into your market
- Margin pressure
- Losing major customer(s)
- Losing key staff members
- Uncontrollable factors leading to business risk
- Unfavourable market trends or developments leading to falling revenues or profits
- Business situations adversely effective marketing efforts
- Significant changes in supplier prices or raw material availability
- Shifts in consumer behaviour, economy, or government regulations that could reduce sales
- New products or technology leading to redundancy and obsolescence of products and services
How do you evaluate the value of a business? The formula to value your business
- On revenues (past & projected)
- Times Revenue Method: In this business valuation formula, the revenue streams generated over a certain period are applied to a multiplier based on industry and economic environment factors. For example, a technology company may be valued at a certain revenue, while a service firm might be valued differently. The times-revenue method is generally used to estimate a range of values for a business. The calculation is based on actual revenues over a certain period, like the previous fiscal year. The multiplier offers a range that can be the basis for the start of negotiations. Thus, the times-revenue method attempts to value a business by considering its sales cash flow streams.
- On profits (operating profit v/s net profit)
- Earnings Multiplier: A company’s profit or earnings (compared to sales revenue) is considered the right indicator of business value and financial prosperity. The earnings multiplier method adjusts anticipated future profits against cash flow that could be invested at the current interest rate over the same period. Thus, it adjusts the current P/E ratio to account for current interest rates.
- Discounted Cash Flow (DCF) Method: This is one of the prime business valuation methods and is similar to the earnings multiplier. The technique is based on future cash flow projections adjusted to compute the current company market value. The DCF method is different from the profit multiplier method since it considers inflation for calculating the present value.
- On MVP
Calculating the market or business value of an MVP (Minimum Viable Product) is key when a new product is launched in the market. With the implementation of the lean methodology of the MVP Development cycle, a product can be successfully launched.
Three steps that help to calculate MVP’s business market value are as under:
- Top-Down Market Size: Here, we take the total market value and deduct from it the MVP product idea’s share. Thus, we need to find the right market, segment the market according to potential users, collect feedback from the various segments, and review it as the entire market’s response to the idea.
- Bottom-Up Market Size: The Bottom-Up approach is the reverse-engineering of step number 1. In this, we need to calculate the potential sales rather than estimating the market share. Here, we make a list of all channels which sell similar products and assess our competition. We have to dive deep to churn out the potential sales of our competitors from various channels and consider the development, manufacturing, and operational costs before the product reaches the customer.
- Competitor Value: This step involves studying the already established market players and figuring out how to create a unique, stand-out entity amongst them. This activity provides clarity on the potential market share we can capture and whether it will help us become a profitable business over time. This is the reality check stage, where we assess our potential business against the competitors’ market hold.
How to value your business – Other ways (based upon the business model, as new-age businesses are to be valued depending upon the business model)
A business model typically describes the customer mix, the ways customers use products or services, distribution methods and promotional strategies, operational tasks, resource requirements, and how revenue and profits are generated. We now look at the business valuation for commonly used models:
- Research traditional business models: like the ‘bricks and mortar’ traditional grocery model, which has now evolved to include E-Commerce as well, the ‘click and bricks’ which model allows customers to buy online or in a local store, the ‘subscription’ model which helps companies to provide a product accurately assess your business’s true financial worth optimise service periodically (e.g. monthly).
- Investigate innovative sales models: Using a ‘multi-level marketing’ model, distributors buy products from a parent company and create a distribution network to sell the products to consumers, earning a profit from their sales and anyone below them. In a ‘direct sales’ model, manufacturers sell directly to the consumer. The ‘auction’ model allows people selling products or services to offer them up for bid, with the customer placing the highest bid to make the purchase. In a ‘brokerage’ model, companies connect buyers and sellers.
- Examine industry reports on leading companies in the industry: In this instance, we can calculate gross profit margin to evaluate and compare companies and their business models, choose the best model for our company, obtain sales and cost data on companies from industry reports or company websites, subtract the cost of goods sold from the revenues reported to determine the gross profit, divide the gross profit by total revenues to obtain the value for gross profit margin, and then use the tools provided by websites to calculate these values.
- Compare gross profit margin results for different companies: A low-profit margin indicates a less profitable company. We can choose a company model which best suits our strategic goals. We can use the resources provided by trade associations and websites to apply the business model to our business.
- Revise our company business model based on customer expectations: The model we choose to implement today may become obsolete tomorrow. We must always be prepared to adjust to prevailing market demands and economic conditions.
How do you value a business? Business Valuation for business negotiations and deals
During business deals negotiations before or after a valuation, both parties have to put their messages across through a clear take or stance. If there is no clarity, then the negotiations can become lengthier, and both parties might lose track or focus. It is vital to evaluate different perspectives fairly and unbiased during a deal or merger negotiation. An independent valuation of the company involved in the merger might involve discounting expected cash flows at the firm’s weighted average cost of capital. Then, the value of the combined business entity (after the merger) is obtained by adding the values obtained for each firm in the first step.
Here are some best practices to be followed for deal negotiations before/after/during business valuations:
- Listen and understand the other party’s issues and point of view
- Be thoroughly prepared (i.e. reviewing the company and people information, similar deals’ information, product & service offerings, competitor pricing, marketing strategies, etc.
- Keep the negotiations professional and courteous. Understand the deal dynamics
- Always draft the first version of the agreement, and keep it ready
- Be ready to walk away if the deal terms aren’t favourable.
- Avoid the bad strategy of ‘negotiating by continually conceding.’
- Keep in mind the time factor.
- Don’t fixate on the deal in front of you and ignore alternatives
- Don’t get stuck on one issue
- Identify who the real decision-maker is
- Never accept the first offer
- Ask the right questions
- Prepare a Letter of Intent or Term Sheet to reflect your deal
- Secure the help and service of the best deal consultant or business valuation consultant.
Based out of Pune, India, Digital Finance Experts (DFX) is one of India’s premier business finance consultants offering a wide spectrum of industry-ready services & solutions, specifically business valuation services customised for prospective entrepreneurs. The company has years of proven expertise in all dimensions of financial feasibility and business valuation and is spearheaded by experienced industry-renowned stalwarts. DFX and its sister organisations like YRC have been strategic, transformational partners for several top-tier clients in recent times, expertly guiding customers on how to value your business. As your trusted business valuation consultant, DFX can help you accurately assess your business’s true financial worth, providing you with the perfect launch pad to kick-start optimising the operations. If you are an aspiring business owner looking out for the best valuation specialists in the industry, please sync up with DFX experts right now to unlock the true potential of your enterprise, scaling up and growing exponentially to stay well ahead of the curve!