If you are considering purchasing a business, coming at an accurate value of that business can be quite difficult. There are several different metrics that can come into play, but no matter which one you use, you’re still basically getting a hypothetical dollar amount.
Even so, you shouldn’t rely on what the seller tells you. You wouldn’t rely on that opinion if you were buying a house – so you definitely shouldn’t with a business. Instead, you should turn to an expert who specializes in business valuations and can provide an independent analysis, much like you order an appraisal when you purchase a house.
Of course, in real estate, there are generally comparable transactions that have taken place recently that can give you some perspective. This generally is not the case with business acquisitions, because the conditions can vary much more widely from one sector to the next.
So how do you get an idea of what a business is worth?
The Canadian Institute of Chartered Business Valuators (CICBV) lists three different types of valuation reports that can give you at least a vague idea of what a business is worth.
Calculation report – This gives you a very approximate dollar value so you can start the planning process for the acquisition.
Estimate report – Once you’re ready to start negotiations and succession planning, this is the right report to run. Most purchasers are facing some constraints in their budgets, so having a somewhat better idea of the value is helpful at this point.
Comprehensive report – When the business is in a risky sector, when there are important issues unique to the situation or when the business is involved in any sort of litigation, you want as much information as possible up front.
What goes into the preparation of each report?
For the calculation report, the independent valuator goes through the financial reports that the company provides. In some cases, the valuator may also sit down with the business’ management to get more information.
For the estimate report, the valuator takes a similar approach but goes through the information more thoroughly.
For the comprehensive report, the valuator provides an opinion to go along with the hypothetical value. This opinion will detail the valuator’s findings about such items as the economic situation for that sector, ongoing market conditions, clientele, competition, financial data, commitments and contrasts with suppliers and any by-laws, patents or shareholder agreements in place. Finally, the valuator provides a justification for the capitalization and discount rates that he used, comparing the situation to an existing financial model.
How does valuation work?
When a valuator determines a value of a business, there are three principles in place. Valuation is dependent on future cash flows, ongoing expectations and capital assets that are tangible. Valuators can use two different basic methods for coming up with a dollar amount, asset-based valuation and valuation based on earnings and cash flow. The first method looks at the company’s net worth to determine a book value, and then it also provides a liquidation value, which assumes that the business settles all debts, liquidates all assets and then gives any cash sitting around to the investors. The second method takes a discounted value of the incoming cash flows for a business. There is also the “going concern value,” in which valuators assume that the business will stay open at its current level and compares incoming flow today with the projected values in the future.
What are some ratios that valuators use to assess a company’s worth?
One of the most commonly used metrics is the capitalization of typical net earnings. You apply a capitalization multiple to future earnings that would come from the acquisition. Then you add non-operating assets to get net earnings going forward. You can run the same calculation using cash flows instead of earnings. As far as future cash flows, another metric involves discounting their value to present value.
There are also some sectors in the service industry in which a business value comes from a multiple of revenues. An example might be a car dealership which has the value of, say, 1.5 times the commissions that salespeople received during a set time period. Either way, it is the negotiations with the vendor that will determine the final purchase price, but it’s always good to have as much knowledge as possible in this investment scenario.