If the tools and choices confronting you in business valuation seem confusing, take heart – you can get through this by following a number of straightforward steps.
Step 1: Gather the relevant data
Just like any project, business appraisal requires that you take the time to plan it. So the first step is to gather together the information you will need to use in your business valuation. Most important are the financial statements for the company. These may include historic income statements, balance sheets, as well we the financial forecasts for the company.
Step 2: Financial statement adjustment
Once this information is available, you would need to review and adjust the financial statements. This second step is often called the financial statement reconstruction or recasting. The idea is that the financials from the company’s books may not represent the true earning power of the business. Since the ability of the business to produce earnings is key to its appraisal, the financial statement adjustments are done to reveal the company’s income generating capacity in a clear and convincing way.
Step 3: Choose your business valuation methods
The company’s financial numbers help you develop a number of inputs that can be used in the actual valuation calculations. The next step is to choose the valuation methods to use in appraising the company. Each method requires that you provide certain inputs from the previous step.
Step 4: Run valuation calculations with each method
At this point you can run a number of valuation methods to come up with an estimate of business value. Usually, the results you get from the different methods vary.
Step 5: Come up with the overall business value
So the next step is to combine them in order to come up with an idea of what the business is worth. One way to conclude the valuation is to calculate an average of the results you get from the methods you selected. Another is to report your valuation as a range from low to high.
As a business person or professional you may have an idea of what a business is worth. Other people you know and trust may have shared their opinion. Or you may have witnessed a sale of a similar company and noted the selling price.
Most owners have a good idea of just how valuable the business is to them. If the company brings in steady income, you may expect that that income stream is worth a lot.
A surprise comes when a business owner sees the offer terms that differ considerably from what was expected. If the buyers make an offer well below the anticipated price, business owners often feel a sense of resentment.
This brings up an important market dynamic – different parties to a business sale transaction may well have very different feelings about the company’s value. That is to say, business buyers and sellers have different goals in mind when looking at a company. If you feel that a business is too expensive, perhaps it is time to look for another target. If the offer you get is below expectations, consider looking for a buyer who may view your business as more valuable.
How can a buyer value the business well below the number the current owners expect? Consider a few challenges a prospective new owner faces:
- Ensuring continuity of the business after the ownership change
- Retention of key personnel
- Keeping the terms of agreements such as supplier contracts and leases
- Replacing aging equipment and machinery
- Recouping the investment of purchasing the company
These and many other factors may affect how the buyer views the business. What worked for the current business owners may well require additional effort and expense from the new management team. Remember that the buyer picks up where the original owners left off. So time, effort and capital required to run the business the way the buyer wants makes a difference. The new owners must think ahead and additional financial outlays will temper their willingness to pay extra for the company.
Market comparisons do help establish a reasonable price for a given business. However, market is notoriously volatile. What buyers are willing to pay today can change overnight as more businesses come up on the market or acquisition funds become scarce.
So the best way to view the market data on business sales is as a guide rather than a fixed number. It is best to think of the market as setting a range of values. Similar companies are likely to fit somewhere in the middle.
Another point of contention often arises with asset rich companies. The reason a business operation may be worth less than its asset base is because the business income falls short of what is expected. A for-profit firm is an income producing entity. So a company is valued first and foremost based on its ability to generate income for the owners.
The assets not committed to this income generation are extra. They may be valuable in their own right, but not necessarily as part of the business. Examples are real estate, underutilized manufacturing capacity or equipment that is not used to its full potential by the firm.
One way to handle this situation is to identify all the assets the business uses and allocate a portion of existing income to each. If an asset does not appear to produce sufficient income, perhaps it is not used to its full potential. In this way you can spot such excess assets and determine their value separately from the business. Then the value of the entire bundle is the sum of the business operations plus any additional and valuable assets.