Why traditional methods of valuation don’t apply to valuing a small business?

The traditional methods of business valuation have been built by corporate finance professionals for large corporations and listed companies. As a result, these methods don’t directly apply to valuing a small business/ SMEs. You need to adapt these traditional methods to derive a more accurate value for an SME.

Common methods of Business Valuation

  1. Discounted Cash Flow (DCF)
  2. Multiples based valuation – e.g. Price/Earnings (P/E) ratio or EBITDA multiples
  3. Seller’s Discretionary Earnings (SDE)

There are many other valuation methods, each with their own benefits and downsides. There’s no one right method. Depending on your business, its circumstances and the reason for valuation you can determine the method(s) you need to use. However, as a small, growing or a start-up business, you need to adapt these methods to get to a more accurate value.

Why traditional methods don’t apply to valuing a small business?

Following are some of the reasons why there is a need to adapt the traditional methods when valuing a small business.

  • Factors determining multiples could vary for SMEs

Due to their simplicity, multiples-based valuation methods like P/E ratio or EBITDA are commonly used by advisors. Determining industry multiples for corporates or listed companies may be easier with comparable data that is more readily available. However, for SMEs or start-ups, that brings complications.

Also, since multiples focus on a single instance of a company’s finances, they don’t take into account the future growth trend or the overall progress of the company. They also don’t take into account the ‘non-financial’ elements that influence the future performance of the business. These include the knowledge-capital, culture, innovation, technology roadmap, life-time value of customers, etc.

  • Growth factors and trends are different

In case of an SME operating in a niche sector or a disruptive start-up, the traditional industry average growth trends will not apply. There may not be anything comparable in the market/industry to benchmark growth trends against.

  • Don’t account for upward (sunk) investment in a small/ start-up business

Every small, growing or a start-up business makes an upfront investment in technology development or to set up the business. By using the traditional valuation methods which look at the financials at a single point in time, you get a skewed image. The initial upward investment is not taken into account. It could be that EBITDA for the next two years looks completely different from the current year as the upward investment is adjusted. But the traditional methods wouldn’t account for these adjustments.

  • Don’t take into account an acquirer’s strategy

This is particularly applicable in an M&A environment. Since these methods are so financially focused, they can overlook a key element that may influence valuation – the acquirer’s strategy. How critical that acquisition is to the other business and what new revenue opportunity it opens for the acquiring business? This is not typically factored into the valuation when using the common traditional methods.

  • Don’t take into account revenue models of SaaS/ tech firms

Most of the new SaaS/ Cloud-based tech firms use recurring revenue/ subscription-based models. Methods that focus on historical cash flow analysis, do not take that into account. They also don’t take into account the lifetime value of the customers via long-term contracts. Taking this into account would present a different future cash flow forecast and the subsequent valuation.

What is the right business valuation method for your SME?

We can conclude that the traditional business valuation methods are not suited for SMEs. They cannot be directly applied to an SME as they would in a large business. You will need modified versions of traditional methods that take into account all factors specific to an SME, to determine a “fair market value” of the business.

To understand all the key factors you ought to consider when valuing a small business in your industry, talk to one of our experts. We will help you get the maximum value for your business that it is actually worth.