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Business valuation

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What is a business valuation?

A business valuation is a process that determines the economic value of a company. This process involves evaluating all aspects of a business to ascertain its worth, using various methods and considering multiple factors, to provide a clear and justifiable value for different business needs and purposes. Business valuations are used for various purposes including: sale of the business, mergers and acquisitions, financial reporting, raising capital, taxation, litigation and strategic planning. Understanding the value of a business is crucial for making informed decisions regarding ownership, investments, and strategic planning. It ensures that stakeholders have a clear picture of the company’s worth, which can facilitate better decision-making and negotiation outcomes.

Several factors can influence the valuation of a business:

Why should I do a business valuation?

Only 2% of business owners know the value of their business.

That’s why Bisvalue have developed a cost effective solution to increase the valuation knowledge for business owners. A business valuation provides a clear and objective assessment of a company’s worth, supporting a wide range of financial, strategic, and operational decisions. It is a vital tool for ensuring that business owners, investors, and other stakeholders make well-informed decisions based on the actual value of the business.

The traditional business valuation process is costly, intrusive, and time-consuming. But business valuation knowledge is essential for every major financial decision a business owner makes. Accurate business valuation knowledge is essential for several reasons. Conducting a business valuation is a critical step that can impact both the short-term operations and long-term strategy of a company.

Business valuation cost effective solutions bisvalue

Here are key reasons why you should consider doing a business valuation

Informed Decision-Marking

  • Strategic Planning. Understanding the value of your business helps in making informed strategic decisions, including expansion, investment, and resource allocation.
  • Performance Benchmarking. It provides a benchmark for assessing the company’s performance and helps identify areas for improvement.

Sale or Merger

  • Selling the Business. Knowing the true value of your business ensures you get a fair price when selling.
  • Mergers and Acquisitions. Valuations are essential in negotiating mergers and acquisitions, ensuring that you understand the value you bring to the table.

Raising Capital

  • Investor Attraction. Potential investors require a clear picture of the company’s worth before committing funds.
  • Loan Applications. Financial institutions often require a valuation to assess the risk and determine the terms of business loans.

Exit Strategy Planning

  • Succession Planning. A valuation aids in planning for succession by providing a clear picture of what the business is worth.
  • Retirement Planning. For owners planning retirement, knowing the business’s value is crucial for financial planning.

Legal and Compliance Reasons

  • Tax Purposes. Accurate valuations are necessary for tax reporting, including estate taxes, gift taxes, and other tax-related matters.
  • Litigation Support. In cases of divorce, shareholder disputes, or other legal issues, a valuation can provide a fair and objective assessment of the business’s worth.

Employee Incentive Programs

  • Stock Options. When offering stock options or other equity-based compensation, a valuation is needed to determine the share price.
  • Employee Buyouts. For companies considering employee stock ownership plans (ESOPs), a valuation is essential.

Understanding Market Position

  • Competitive Analysis. It helps in understanding where your business stands in the market compared to competitors.
  • Industry Benchmarking. Identifies how your business compares to industry standards and averages.

Insurance needs

  • Insurance Coverage. Ensuring you have adequate insurance coverage for the actual value of your business assets and operations.

Partnership Agreements

  • Buy-Sell Agreements. Provides a basis for buy-sell agreements between partners, ensuring fair transactions in case of buyouts, retirements, or death.

Personal Financial Planning

  • Net Worth Calculation. For business owners, the business often constitutes a significant part of their personal net worth. Accurate valuation is crucial for comprehensive financial planning.

Three most common small business valuation model categories

Valuating your business is crucial. Valuating your business before you think you really need to evaluate it is even better. However, many business owners only start to contemplate a valuation process in the midst of a divorce, corporate breakup or a selling process. Unfortunately, this makes you miss the bigger picture.

Valuating your business will allow you to see how far you’ve come and benchmark against yourself for future reference, but it will also give you a snapshot of where you are today. After all, most of us are in business in order to create value – makes sense to know your own value then, right?

A masterpiece and a work-in-progress at the same time

Valuation models today are both a science and an art. It is both magnificently accurate and abstract, intriguing and complex at the same time. There are several different types of valuation models.

They all come with their own set of advantages, alongside their disadvantages. In textbooks and research papers, it is generally established that all models would give the same results if applied consistently and without any restraints. However, since most models today include a forecast of the future, the models are applied with some limitations.

The limitations will decrease the level of accuracy in varying ways, depending on model. We’ve selected the three most common business valuation model categories and will discuss the implications of all of them. Enjoy!

Direct cash flow models

As the name gives away, this model is based on the cash flow that is leaving or coming into the company. They can be both direct and indirect, i.e. the models focus directly on the cash flows to the shareholders or indirectly on the cash flows generated by the company from an operating perspective. Consequently, it includes models based on discounting of dividends to the shareholders of the company, but this only highlights how the funds are being distributed, not the value being created. The target here is on cash flow model’s focus on cash generation.

The most commonly known indirect cash flow model is the free cash flow model. It’s useful when you want a view over your current cash generation status from your operations which is the key in value creation. Theoretically, this is the core of most models, but in practice it is tough. Cash flows often vary a lot over time, making them difficult to forecast.

Relative valuation models

Relative valuation models are based on comparisons with other businesses in the same industry. By looking at similar companies and their valuations, these models try to analyze your business in relation to others. Relative methods can then illustrate if a business is over- or undervalued compared to similar enterprises. However, more times than not, it is quite dangerous to assume that the market has it figured out. It can be argued that it was the lack of critical thinking that led us into the 2008 financial crisis, or into the Greek crisis in 2011.

Sometimes the market values an entire industry inaccurately, and we find it best to be aware of those risks. Nonetheless, we are here to discuss the model. In order to make a good valuation, the key ratios that are compared should be broadly equal to the other companies. This is why you should be careful of which ratios you choose. Earnings measures that are defined in the same way across companies is a good place to start! But again, the limitation is found in the market itself. Since the economy changes over time, an industry’s key figures from last year can be misleading when analyzing a company today.

There is a saying that goes something along the lines of “important things should be repeated, important things should be repeated”, which is why we need to mention the significance of valuating your business again. If you are looking to sell, or bring in more equity, the need for valuation is obvious. But valuation is also a powerful tool when managing your business. Your strategic decisions are more easily tracked in value, and not just in money. Furthermore, it gives you a holistic view over your company, and helps you foresee the consequences of your actions.

Now that we have that covered, we can return to the different methods of valuating a business. It can be difficult keeping track of the different limitations and benefits associated with them. In the previous post we discussed two of the models: accounting based valuation and relative valuation models. In this post, we are going to look at the last of the three most common business valuation model categories, which model we like the most and of course – why.

Accounting valuation model bisvalue

Accounting-based valuation models

Valuation models that are based on accounting usually originate from cash flow models. They’re reworked and adapted so that it is possible to use accounting information directly in the model. So accounting models are based on the book value of assets and liabilities. They are also based on historical cost (or whatever valuation principle is used in the financial statements), which ignores opportunity costs and replacement costs as well as the time value of money.

The models rely on the clean surplus relation, i.e. that changes in the equity of the company can solely be explained by net income and the transactions with the shareholders. The true benefit of these models is that they use the balance between the three financial statements; income statement, balance sheet and cash flow statement, to indirectly derive cash flows while having income and balance sheet data directly as inputs to the valuation.

Residual income valuation model – accounting and valuation in a golden mix

This may not be the most well-known valuation model, but it is widely used by analysts. Let us tell you why. The residual income model discounts future excess returns based on available accounting data. Now, residual income is more than excess cash, it is the income that is left after having accounted for the true cost of capital. The income statement includes one’s cost of debt, but usually ignores other equity costs. The residual income model basically looks at the cost of equity as the stakeholder’s opportunity cost, giving a more accurate value to the business.

Compared to many other models, the residual income valuation holds one distinct advantage. It is based on the comparative stability of accounting measures, while the commonly used free cash flow model is based on volatile cash flows. Cash flow figures are considered more uncertain to base future forecasts on, as the numbers tend to vary a lot over time. On the other hand, this is where you have to be a little careful. Since there is potentially a bit of management discretion in accounting numbers, making your forecasts must be done after an analysis of the quality of the accounting data at hand. That being said, the residual income model is growing in popularity as it can give you a pretty clear look at what the actual intrinsic value of your business may be.

The importance of business valuations in small companies

Know your value today – decide your value tomorrow

A common misconception among entrepreneurs is the notion that you only need to know the value of your business once you are ready to sell. But ask yourself this: do you own all or a part of a business? Do you want to retire some day? Are you planning to grow? If you answered “yes” to any of these questions then you are definitely going to appreciate knowing the value of your business.

In many cases, however, business owners are too late in realizing the importance of valuing their business. This is especially common among small and medium-sized businesses. The impression that a valuation is complex, costly and very time consuming are some of the reasons why business owners tend to procrastinate completing a valuation. But, in starting too late, you will have little to no chance to increase the value of your company before a defining moment. Defining moments can be anything from seeking investment, to adding a new owner, to selling your company.

Where are you now, and which direction are you headed?

A business valuation will give you a pretty solid idea of how your company is doing today, but also an insight as to where you are headed. Knowing which areas need to be improved in order to increase value is an extremely valuable part of business valuation, but it’s often forgotten. Since many business owners conduct a business valuation at the exact time they need it, it leaves them with little to no room to actually improve the results. A valuation of your company could show which areas need to be improved, and can thus serve as the foundation for strategic decisions aiming to develop and improve your business.

Getting down to business

Traditionally, valuations are made in connection to a sale and/or purchase of a company. Nevertheless, there are other scenarios where a valuation is needed. If we put personal matters like divorce and retirement to one side, it still leaves us with several business situations where a valuation is essential. If your company is big enough, a listing on a stock exchange could be an option, meaning that it is of the utmost importance to set a price that the market believes is fair and thus accepts. If you need to report estate tax, or gift tax, a business valuation provides the value of your ownership and determines the amount of future payments.

Do you want a good price or a great price?

A valuation of your company can mean the difference between a good price and a great price. It could help set the floor and/or ceiling values for negotiating. By giving yourself enough time to improve your valuation results, the price tag during a sales process could significantly change. It is also worth mentioning that a business valuation is an incredible help during a negotiation, but it does not replace the negotiation itself. In an ideal situation, you are able to value your business each year to continuously track the development of your company’s value. This will enable you to see the effects of your value-creating actions. If you value your business, then you should know the value of your business!

How to increase the business value of your small company

Make sure your business stands out

There are a ton of different valuation models and most of them have different advantages and disadvantages in regards to assessing a fair and trustworthy value of your company. However, they all have one thing in common: growth and profitability are the key drivers to creating value. Whether the valuation model directly or indirectly focuses on growth and profitability as key drivers, they always play a big role in the valuation process. Why? When your company consistently delivers higher returns than what your investors require – your company creates value far beyond the recorded values on your balance sheet. So how do you actually increase the value of your company? It’s an important question, and one we hope to answer here!

All of these statements are very important and, even though some of them might be overlapping, they are all worth mentioning. Another interesting observation is that they are all closely related to growth and profitability. Like we’ve mentioned before, the longer you have to prepare your valuation, the more control you have over its results. This is a pretty good reason to conduct a valuation annually, in order to track your improvements. See your conversion rates go up, your costs go down and your productivity increase! So, to be able to see the results over time, you need to make strategic decisions. Even though this list mentions valuable strategies, there are other actions you can take in order to increase the value of your company. A few suggestions are proven scalability, financial foresight and a strong competitive advantage. Keeping key employees on board is also a good strategy as they bring stability and invaluable knowledge.

A valueable list

Understanding a valuation

From a pure valuation perspective, the most important topics are recurring revenue, predictability, clean books and growth. The other activities mentioned in this list will generate those key drivers. This list gives you a pretty good understanding of which actions our valuation model takes into consideration in order to emphasize growth and profitability. It’s pretty much common sense that a buyer is willing to pay more if they see profits increasing, as it shows a more stable future. Make sure to align your actions with your value-creating-goals, to assign the task to the best person for the job and to always have a back-up plan! These lists will help you build a stronger and more valuable company!

The key elements to improving value are 1) return above the cost of capital; 2) beat expectations implied in earlier valuation; 3) grow only if your returns are above cost of capital, i.e. focus on profitability first and growth thereafter.

Earn your right to grow! Continuous valuations serve the purpose of helping you keep track of your results.

Understanding valuation

The value of business valuation in small companies

The concept of business valuation has been around for more than a century, but many people still find it difficult to grasp. We’re here to tell you that it’s actually surprisingly simple! Business value is created when a company grows, and their earnings from their capital is more than their cost of capital. That’s it!

What’s your business worth?

A valuation of your business was previously known to be costly and very time consuming. It would often involve contacting financial advisors, looking through accounts and analyzing numbers. In general, there are three main areas you could base your business valuation on: assets, market value or fundamental value. Asset-based valuation does not apply to all business types, and a market value really only works when there are enough similar businesses to compare your company to. When looking into fundamental value approaches, the most common method is the discounted cash flow model (DCF). A more modern approach to business valuation is instead to discount future excess returns. This is based on available accounting data, which many perceive to be more stable and readily available than cash flow measures. By finding out what your business is worth today, you will be able to track change from year to year, plan for an increase of value of your business and influence the right actions.

Today’s action – tomorrow’s value

Remember that business value is created when the return on capital is more than the cost of capital. Essentially, it’s like a health check for your company. Regardless if you’re planning on adding shareholders, strategizing about growth opportunities or looking to buy out partners, you will want to have an updated business valuation at hand. More times than not, people don’t think about business valuations before they need one. Those situations may be quite stressful, and the extra pressure of uncertainty is unnecessary. By valuing your company today, your future value will be easier to determine, track and benchmark against.

The beauty of a business valuation is that nothing is set in stone. If you don’t like the numbers that you see – change them! Record and trace key numbers, educate management and develop an action plan to reach your goal value. By getting a business valuation, you will clearly see which areas need extra care. Setting goals and knowing where you want to go is half the battle.

The difference between price and the company valuation of a small business

The difference between the price and the value of a company is simple, yet crucial. Knowing the distinction can mean having leverage during your next negotiation, the difference between making a bad or a great investment, or just simply making good conversation at your next dinner party. After reading this, you will be able to properly identify the difference between price and value in a negotiation.

Value is value?

Let’s start off with understanding value. Value can be broken down into two major sub-divisions: book value and market value. Book value is, as the name gives away, what is in the books. Accounting will show a company’s value by subtracting liabilities from the assets. What is left if a company were to sell off its assets and settle its debts would be the book value of that company. Book value is accounting value which is shareholders’ equity.

Fundamental value, or intrinsic value, is the estimated value of the firm based on the expectations of future cash flows. These estimates are based on an evaluation of earnings potential, investment needs, financing opportunities, business models etc. These are then adapted and inserted into a valuation model of your choice.

Finally, market value is the value of the company according to the stock market. The easiest way to calculate this is multiplying the number of shares with the current market price. This is also referred to as a company’s market cap. Market value is usually the value that is referred to by newspapers and analysts as it reflects how much you would have to pay in a purchase situation.

Fundamental value in the market

There are a couple of general principles when looking at the relationship between market value and fundamental value. When the fundamental value is larger than the market value, the market is for some reason undervaluing the company compared to its actual value. Many investors seek out these companies as they are viewed as a great investment opportunity. In the scenario where the market value is greater than the book value, the market usually has a firm belief in the potential earnings of a company. When market and fundamental value are equal, the market and your performed fundamental valuation are agreed upon the value.

Knowledge might determine the price

Moving on to price, i.e. the market value. The price of a service, good or business has for a long time been viewed as the compromise between what a buyer is willing to pay and the price a seller is willing to sell for. That logic is beautiful in its simplicity. Practically, there are several different factors that come together to determine the price. These include the number of interested buyers, the sense of urgency of the deal and the negotiation power of the involved parties.

Reaching an agreement

The bottom line is that both value and price will fluctuate during the lifespan of a business, and maybe especially so in a negotiation. The fundamental value of a business is primarily based on your belief and trust in the company. Do you believe in the company’s ability to grow and stay profitable? It also depends on the industry, and the timing – is there a peak in interest during a specific period in time? This might spike prices. To evaluate the price and decide on your willingness to invest, you have to weigh in all factors and establish a link between the fundamental value of a company, its accounting information and future prospects for the company. Based on that, the buyer and seller can hopefully reach an agreement on price – in all its beautiful simplicity.