4. Determining the Business Value
Joke aside, the value of your business is the value that can be absorbed by the market, by a potential buyer. But determining such a price is not easy. There are several ways to evaluate a business, ranging from assets (patrimony) to future profits. Of course, no method can be used in isolation; the current market, economic trends, and other similar businesses already sold must be taken into account.
Here are three methods that are used most often in business valuation:
1. Asset-Based Approach
An asset-based approach is a type of business valuation that focuses on the value of a company’s net assets or the fair market value of its total assets, minus the total of its liabilities. The asset-based approach basically represents the cost of recreating the business. There is place for interpretation in the asset-based approach, in terms of how the value of the items taken into account is measured.
Here is a simple example of setting a sale price, based on patrimony. Suppose you want to buy a pizzeria. The seller’s list might look like this:
- Equipment: 80.000 RON
- Inventory: 2.000 RON
- Delivery vehicle: 15.000 RON
- Invoices: 4.000 RON
- Unpaid suppliers: 2.000 RON
- Trademark: 10.000 RON
- Goodwill Fund: 10.000 RON
- Total: 119.000 RON
By looking at this example, you can easily see how quickly something that sounds so simple can become very complicated.
How do you know, for example, that Goodwill is worth $ 10,000? And even if the seller believes this, how will he prove that such a value reflects reality?
This is one reason why it is always wise to seek professional help with your business valuation.
2. Earning Value Approach
This business valuation method is based on the idea that the true value of a business lies in its ability to generate future profits. The most common approach is to establish the business value based on profits generated in previous years.
With this approach, an evaluation determines an expected cash flow for the company using previous earning records and multiplies the expected cash flows with a capitalization factor. The capitalization factor is the recovery rate that a reasonable buyer expects from the investment, as well as a measurement of the risk that the expected profits will be achieved or not.
Another evaluation approach is when, instead of an average of past earnings, an average of the expected trend in future earnings is used and applied to the capitalization factor.
The capitalization rate can be:
- For a well-established business, with strong earnings history and a good market share, a capitalization rate of 12% to 20% could be considered.
- For an unpredictable business, in a volatile market, there is a tendency to use much higher capitalization rates, say 25% to 50%.
If we use the example above, the pizzeria valued at 119,000 RON, considering that it can prove an annual profit of 50,000 RON and has a capitalization rate of 33.33%, can be sold with 150,000 RON. So, the sale price can be much higher if it is supported by a profitable outcome.
3. A Combination of Asset-Based and Earning Value Approaches
If we use the same example as above, and add into equation the building where the business operates, valued at 250,000 RON, then the selling price of the business could be 400,000 RON (250,000 RON for the building + 150,000 RON for the business).
There are also cases where the buyer does not want to buy the building or the seller does not want to sell the building. In this case, the business can be evaluated using the first or second method to determine the value of the business, provided that the seller and the buyer sign a lease for the space required for operating the business.
If possible and not too expensive, get a business valuation using specialists. Anyone can evaluate a business, but a professional valuation will be viewed more favorably by potential buyers, and it may save you time and money later, when you have to negotiate the selling price.