What is involved in a business valuation?

What is business valuation?

In simple words, business valuation is the process of determining the worth of your business. It is about estimating the price a potential buyer would be willing to pay for it. It may sound straightforward and some may think that a simple analysis of the financial performance of the company should be enough, but the devil is in the detail.

Business valuation is as much of an art as it is a science. The number crunching financial analysis (science) is matched by the rational assessment of the market factors as well as the educated guesses of the value of intangible assets (art). Along with the financial skills, this requires knowledge and understanding of the business and its market to determine a credible valuation or ‘Fair Market Value’.

Business valuation – what’s involved?

Many elements need to be taken into account when planning to undertake business valuation.

  1. Conducting Financial Analysis

Any business valuation process involves a detailed financial analysis. This includes analysing the balance sheet, reviewing the cash flow statements to understand the financial health of the company, business profitability, etc. A simple comparison of a few years’ financial performances can provide a good view of the growth trend of the business, which greatly influences the final estimates.

This highlights the significance of maintaining a good financial management culture and discipline within your SME at all times.

  1. Normalising Financial Statements

SMEs typically don’t set out to manage their finances with a view to pursuing business valuation. As a result, the financial statements (balance sheet, cash flow, etc.) are not aligned to facilitate this process. This can negatively impact your company’s valuation assessment and prolong the process. So, typically ‘normalisation’ is required to align the financial records so they reflect the true picture for the business. A financial accountant can guide you around the different types of normalisation methods based on your existing financial management practices.

  1. Choosing Valuation Approaches

The three common approaches to business valuation are asset-based, market-based and income-based approaches. Each has its merits and demerits and are used for specific reasons; however, it’s advisable to use more than one approach to provide a more balanced view.

  • Asset-based approach – This is a typical financial number driven approach that provides a balance sheet view and focuses on the net asset value (NAV). It’s based on the concept of substitution i.e. how much will it cost to create a similar business with similar economic/ financial benefits. Using the asset-based approach assumes that the business is equal to the sum of its parts. This makes it a weak model, which doesn’t properly allow for intangible assets in valuation. So, typically it results in a value that is lesser than the fair market value. The asset-based approach in effect assesses the entry barrier value and is more suited for capital-intensive industries like steel, telecoms, transportation, etc. It is also considered more preferable for mature or declining businesses.
  • Market-based approach – In contrast to the asset-based approach that has an internal focus on your assets, the market-based approach looks for signs from the real market. The valuation advisor weighs your business up against a business of a similar size in the same industry or the upstream/downstream industry. While the asset-based approach is based on substitution, the market-based approach is rooted in the principles of competition.
  • Income-based approach – This approach is based on the assessment of future business income and potential risks. It basically uses either the capitalisation or the discounting method. Both the methods are used in different situations; capitalisation method when future growth and margin is stable, while the discounted method is used where more flexibility is needed as it allows for variation in future margins, growth rates, etc.

It’s important to note that every approach delivers a different estimated value. There will also be some variation and bias based on the individual’s assumptions of the market and the risks involved. Your business’ circumstances, industry and your reasons for valuation will determine the approach that is best suited for you.

  1. Factoring in the Cultural Due Diligence

Organisational culture plays a crucial role in the performance of a company, especially in the long run. Depending on the objectives for business valuation, culture could be a key factor in influencing the final value. This is particularly useful in situations like company takeover or M&A where uncovering hidden cultural problems is of high importance to ensure its long-term success.

  1. Factoring in the Operational Performance Review

While financial analysis provides an overview of the financial performance, a business valuation also needs to consider operational performance elements that influence the final estimation. These include operational efficiency, knowledge management, established systems and processes within the business, sales/lead generation engine, the brand itself, etc. If these are all well optimised, they will reflect in the financial performance as well as increase the value of your business.

 

For an SME considering business valuation, the key is to have your house in order before embarking on this journey. This includes sorting out financial paperwork, cash flow management, a solid outlook of the sales/revenue forecasts, operational effectiveness and creating a performance-driven healthy organisational culture.

To get a better understanding of all the elements involved in business valuation and to ensure that you have your house in order to get the maximum value for your business, get in touch. We can quickly assess all the value drivers in your business that you can optimise in order to maximise your business value.