The Top 3 Ways to Value Your Small Business

Determining the value of a small business is not always a straightforward process but it is worth the effort to get an accurate valuation. But you may be wondering why it is important to have a business valuation in the first place? There are actually several reasons:

• A business valuation can help you make informed decisions about selling, buying, or growing your business.
• It can provide insight into how much your business is worth to potential investors.
• Lenders often require a business valuation report as part of the loan application process.
• A valuation can also be used to secure investment capital.
• It can help you determine the value of your business in the event of a divorce or other family dispute.
• It can establish a fair price for buying out a business partner.
• A business valuation can also help you get a clear picture of your business’s financial health.

So, how do you go about valuing a small business?

Professional appraisers typically perform valuations, and several different methods can be used. The right method for your business will depend on a number of factors, such as;

• The industry the business is in.
• The location of the business.
• The profitability of the business.
• The growth potential of the business.
• The assets and liabilities of the business.
• The purpose of the valuation.

The valuer will also take into account market trends and the economic environment when determining the value of a business and will be able to advise you on the most appropriate method for your business.
We will briefly overview the three most common valuation methods used for small businesses and their advantages and disadvantages.

1. Discounted cash flow (DCF) method

The discounted cash flow method is an income-based approach that relies on the premise that the value of a business is the present value of all its future cash flows. The underlying assumption of this method is that the company is a going concern and will therefore continue to generate cashflows into the foreseeable future. This method incorporates a risk-adjusted discount rate to account for the time value of money and the risks associated with the cashflows. Typically the weighted average cost of capital (WACC) is used as the discount rate, which accounts for the different types of risk associated with the investment. The WACC is determined by taking into account the cost of equity, which is the return that shareholders expect to earn on their investment, and the cost of debt, which is the interest rate that the business will have to pay on any borrowings

The period over which the cashflows are projected is known as the forecast period, which is generally until the business reaches a stable state and is no longer growing. Typically, this will be up to 5 years. However, this depends on the industry and specific company situation, as some companies may be able to forecast accurately for ten years or more.
The value of cash flows beyond the forecast period is termed the terminal value and is typically calculated using either the multiple of earnings method or the perpetuity growth method.

Advantages:

• The DCF method is based on actual cash flows rather than accounting profits.
• It is a forward-looking method, which means it considers the expected future growth of the business.
• It is a more accurate representation of the business’s true value.
• It can be used to value businesses of different sizes and in different industries.

Disadvantages:

• This method is complex and requires a number of assumptions about the future cash flows of the business, which may not be accurate.
• It may be difficult to find comparable companies to use as a reference point for the discount rate.

2. Capitalisation of future maintainable earnings (FME)

The capitalisation of the future maintainable earnings method is also an income-based approach that involves capitalising the after-tax earnings by a multiple to arrive at the company’s value. By earnings, we mean the net operating surplus, which is the difference between revenues and all expenses, including interest, tax, depreciation and amortisation. This method is a simplified version of the discounted cash flow method and is typically used to value small businesses.
In the FME method, only a single figure for the company’s earnings is considered and not the entire stream of future cash flows. This makes it simpler when estimating the value of a small business, as there are typically fewer variables to consider.

The future maintainable earnings are estimated by considering historical earnings with current and forecast earnings. The historical earnings of the business are adjusted for non-arms length transactions, one-off items and any exceptional items. Any surplus assets and liabilities are also taken into consideration in the FME method, as they are not required to generate future earnings. They are typically deducted from the value of the business.

The multiple used in the FME method is typically determined by looking at comparable recently sold companies. The earnings multiple can vary depending on several factors, such as the size of the company, the industry, the growth prospects and the level of risk. A smaller company with high growth potential will typically have a higher multiple than a larger company with low growth potential.

Advantages:

• The FME method is a relatively simple and easy-to-understand valuation method.
• This method is typically used to value small companies.
• The FME method takes into account several important factors that can impact a business’s value, such as historical earnings, current earnings, growth prospects and the company’s competitive position.

Disadvantages:

• The FME method is a simplified version of the discounted cash flow method, and as such, it may not be suitable for businesses with a more complex structure.
• This method relies on the use of comparables which can be challenging to find in some cases.
• The FME method does not take into account the entire stream of future cash flows, which means that it may not be an accurate representation of the true value of the business.

3. Asset Accumulation method

The asset accumulation method focuses on the fair market value of the company’s physical and intangible assets and liabilities. This method also includes the fair market value for intangible assets not shown on the balance sheet and an estimated value of liabilities not on the balance sheet. The value of a business is determined by subtracting the fair market value liabilities from the total fair market value of the assets to get the net asset value. As this approach focuses on fair market value and makes adjustments for assets and liabilities not on the balance sheet, the value derived using this approach will not always be the same as the company’s book value.

Advantages:

• This method is easy to calculate as it only requires a list of all the assets and liabilities of the business.
• It is a transparent method as it shows exactly how the value of the business is derived.

Disadvantages:

• This method does not take into account the earnings potential of the business and so may not reflect the true market value of the business.
• This method may also be less accurate for businesses with a large number of intangible assets.