The Valuation as Management Tool

How much is your business worth?

A business valuation requires consideration of many factors that govern the success of the business. These include how well the business is performing and its potential for growth.

Most business owners seek a valuation when they are looking to sell the business. It is certainly necessary to have a valuation to sell the business, but owners should recognize the full benefit of having a valuation extends beyond selling the business. It includes making the business as successful as possible, even if the owner has no intention of selling it in the near future.

Hence, the valuation is a useful tool to improve a business and at the same time provides the information the operator needs when he is interested in selling it.

It makes good operational sense to value the business regularly, such as once a year. A formal valuation may be time consuming, but it provides a focus for performance.

Key values to consider

Much of the time is in determining key values, such as debt, gross profit, net profit, earnings before profit, etc. Accuracy in these areas is important, but if the valuation is more for the purpose of business improvement rather than sale in the near term, the owner can use assumptions and estimates. This way, the process will be much less onerous and less expensive.

Once a valuation has been done, the same bases and assumptions can be used to update the valuation in the future. The aim is to create a valuation process so that factors affecting the performance can be evaluated regularly.

Owners should understand the elements of business valuation so their expectations for the business are realistic and they can take steps to ensure it is operating well and can reach its potential.

An accountant can help with a current valuation as well as identify ways to increase the value that are specifically suited to the business. Owners can then undertake the process themselves to help measure the success, until such time when they want to sell.

Understanding the value of their company also allows owners to move quickly when acquisition opportunities arise. They are more likely to know what the real value of the opportunity is to their business.

Hence, the valuation is important to both a potential seller and a potential buyer.

Elements of a valuation

The value of a business is often expressed as a multiple of the profits of the business. The lower the risk of earning those profits, the higher the multiple.

For example, the value of a business in a particular industry may be four times its earnings before income tax (EBIT). The business will earn 25 percent on its value. A more risky business may only be valued at three times EBIT, representing a 33.3 percent return on value.

The measure of profit used in the valuation calculation must exclude any “abnormal” income and expenses, as well as interest. In some cases, it can also exclude depreciation and amortization of fixed assets. But it must include a deduction for the commercial remuneration paid to the owner.

Often, the driver of the owner’s remuneration is to minimize tax, and bears no resemblance to a remuneration that would have to be paid to an employee undertaking the same tasks. In other cases, businesses are run at a level where the owner’s remuneration is acceptable to that owner but would be unacceptable to someone else.

Hence, in valuing a business, consideration must be given to the time and effort put in by the owner (and owner’s family) and an adequate reward must be identified.

In the process of doing this, it is common for the owner to realize that their reward really isn’t sufficient, and they then look at ways to increase it. These include employing others to do more of the administrative tasks, delegating management to others, introducing more efficient accounting processes, and working more “on” the business rather than “in” the business.

Goodwill influences value