Valuing a business might not be one of the top few things that you would do, however, it is essential to know a business’ worth when you are:
buying or selling a business;
selling shares in a business;
getting a business loan;
attracting investors; or
valuing your own net worth
There is no fix method of valuating a business, and the degree of complexity varies for each. Nonetheless, each method has its own unique advantages and disadvantage, so do keep in mind that consulting a business broker or professional valuer might be a good idea in assessing your business!
Valuations are typically based on a combination of methods and a well-prepared, balanced and independent valuation can help expedite negotiations to offer a more thorough picture of a business’ value.
The price that buyers are prepared to pay is also deemed as the business’ real value. Prices paid for similar businesses in the recent past should also be noted down before deciding on a method to value your business. Although this method of benchmarking cannot be treated as a formal valuation, it serves as a primary guide to the probable market price.
The standard valuation methods are:
calculating a business’ net worth
valuing based on the business’ income/profits and the expected return on investment (ROI)
Valuation based on net worth
A business’ net worth is fundamentally the differences between what it owns and what it owes. In short, net worth = asset – liabilities. Both tangible assets, such as machinery and equipment, and intangible assets, such as goodwill and intellectual property (IP), has to be taken into account when computing the business’ assets.
While it seems like a relatively simple method, one of the limitations of this method is the difficulty in valuing a business’ intangible assets. Furthermore, the premium that might be justified for strong growth businesses or discounts for businesses that are in decline are not taken into account.
Valuation based on annual net profit
Valuating based on the business’ annual profit is a more preferred valuation method, and many industries have a ratio for valuating in this manner. A secure business might be valued at 3 times its annual net profit in the marketplace. Conversely, a less secure business in the same industry might sell for only twice the annual net profit. For example, a secure business in the marketing industry has a net profit of $100,000. If the average valuation for a marketing industry is 3 times net profit, the business will be valued at $300,000.
The only limitation of this valuation method is that it doesn’t consider other factors such as fluctuating target market. For example, if a business is experiencing increasing annual net profit, it will not be reflected under this valuation method.
The focal part of any valuation method is the business’ assets – both buyers and sellers must denote which assets are to be sold in any transaction. There are 3 types of assets that business have, and each asset has to be considered separately:
current or short-term assets – i.e. full value of assets expected to be realised within a year
non-current or fixed assets – i.e. full value of assets not expected to be realised within a year
Valuing current assets
Current assets refer to a company’s assets where the full value of the asset is expected to be realised within an accounting year or in other words, assets that are realistically expected to be converted to cash within 12 months. Examples include accounts receivable, inventory and other liquid assets.
To effectively value a business’ current assets, the business’ stock on hand and balance sheet has to be reviewed.
Valuing non-current assets
Non-current assets are a company’s long-term assets where the full value of the asset is not expected to be realised within an accounting year. Examples include land, building, plant and machinery, tools, motor vehicles and computer equipment.
This is usually valued by deducting the accumulated depreciation from the original purchase cost.
(Original purchase cost – accumulated depreciation = current value of the non-current asset)
For example, a computer was bought by a business at $1,500 2 years ago and is subjected to depreciation. The useful life of the computer is 5 years, thus the current value of the computer is $900.
i.e. Annual depreciation = $1,500/3 = $300 à current value = $1,500 – ($300 x 2 years) = $900
However, it is important to verify the market value of high-value assets as the depreciated value of the asset might not be the same as the market value.
Valuing intangible assets
Valuing intangible assets is not as straight-forward as valuing tangible assets. As these assets do not have a physical nature, it is challenging to determine its exact value. Examples of intangible assets include patents, copyrights, goodwill, customer lists and IP. IP can be tough to value as it does not depreciate in the same manner as tangible assets. Thus, seeking assistance from professional accountants like us to value intangible assets might be something you should take into consideration!
It is important to choose a good combination of valuation methods in order to effectively value a business. If you are unsure about selecting the right valuation combination or the current value of the business’ asset, do not hesitate to contact our office.