How do you Value a Business?
If you are buying or selling a business you will appreciate the difficulty involved in working out just what is the value of a business? Business sales people tend to focus on industry multipliers i.e. some number multiplied by annual sales revenue. The multiplier basis really is a very generalized approach to business valuation where businesses within industry groups are lumped together and a multiplier applied that will on average for that industry provide an broad indicative valuation. However it is of no use in identifying businesses that offer potential looking forward and hence is a very poor business valuation approach. A superior valuation methodology is the Calculated Return on Investment approach. This methodology is applied in the original Business Valuation Model Excel.
Calculated Return on Investment - the best way to value a business
A business valuation should provide a realistic and justifiable value of a business. This value represents the level of investment in a business that will provide an acceptable return. In practical terms this is the purchase / sales price of a business or the maximum amount of capital applied in business establishment. In a tight economic climate establishing a valid understandable business valuation is increasingly important for both buyers and sellers.
The price paid for a business should be related to the investment return the business provides. A business is basically an asset that generates income and profit. The value of the business is determined by the required return on investment.
Business Valuation Calculation using Return on Investment
If the business generates $100 of profit per annum and the required return on investment is 10% per annum then the price of the business that provides this return is $1000.
Business Valuation = Profit p.a. / Return on Investment p.a.
$1,000 = $100 / .10
It is future profit that is the key determinate in this equation, the higher the forecast profit the higher the business valuation. Developing a solid forecast based on the macro and micro business drivers is important. This will also allow a risk assessment to be made which will impact the required return on investment. The higher the perceived risk the higher the required return on investment and the lower the business valuation.
You can Download Business Valuation Model Excel and easily apply this methodology to assess the value of any business.
Value of a valid Business Valuation for Sellers
- Highlights the businesses current financial performance.
- Forecasts the future business financial performance.
- Allows business potential to be highlighted/demonstrated in financial projections.
- Acts as a quantifier of business risk and in turn required return on investment. The higher the risk the higher the required return on investment.
- Provides Sensitivity Analysis to determine a business valuation range based on optimistic to pessimistic financial forecasts.
- Allows interactivity and the ability to play with a range of what if scenarios.
- Promotes active consideration of internal and external business drivers and the identification of both business opportunities and threats.
- Enables the display and explanation of a business financial forecast and associated business valuation to prospective buyers.
- Allows sellers to test forecast variations to determine the impact on business financial performance.
- Provides a strong negotiation tool in determining a final business sale price.
Value of a valid Business Valuation for Buyers
For a business buyer the value of a Business Valuation includes most of the points outlined for a seller plus:
- Allows validation and testing of financial data provided by sellers.
- Applies basic numbers Revenue, Variable and Fixed Costs to assess real business performance.
- Forecasts the future business financial performance from current basic numbers.
- Allows prospective business buyers to test forecast variations to determine the impact on business financial performance.
- Allows the buyer to incorporate specific skills / ideas / expertise into business forecasts to assess the business potential based on the value-adding they can apply.
- Provides a strong negotiation tool in determining a final business purchase price.
Business Valuation for Negotiation
Applying Business Valuation as a negotiation tool is under utilized. In essence a business valuation is the amount of money that can be invested in a business while ensuring the required return on investment is achieved. The return on investment is determined from the business surplus and the amount of investment i.e. purchase / sale price. The required return value is influenced by the business risk and the opportunity cost of investing in the business. As the business price is the variable under negotiation and the opportunity cost can not be influenced there are only two negotiable variables left....
From a sellers negotiation perspective:
- Demonstrate an increase in the business surplus and the price can be negotiated upwards.
- Demonstrate a decrease in business risk and the price can be negotiated upwards.
From a buyer negotiation perspective the reverse is true:
- Demonstrate a decrease in the business surplus and the price can be negotiated downwards.
- Demonstrate an increase in business risk and the price can be negotiated downwards.
Download Business Valuation Model Excel to develop your own business valuation. This proven software applies relative indicators for future performance which allow a forecast business surplus to be determined based on the changing business environment. It also provides sensitivity analysis to assess the range of forecasts (optimistic to pessimistic) and applies these to calculate a business valuation. Using a business forecast that considers the dynamic environment in which the business operates is the basis of a verifiable business valuation. Applying Sensitivity Analysis allows a range of scenarios and corresponding valuations to be analyzed.