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

The difference between the calculated value of the business and the total value of its tangible assets, such as assets, stock, debts, plant and equipment (minus any debt) is the business’ goodwill. If the calculated business value is less than the tangible assets, the goodwill is negative.

Goodwill is not something that is calculated directly, but it is the result of the calculation described.

The value of goodwill is enhanced by improving the business value through factors such as handing management over to others to reduce the owner’s personal association with the business.

If accounting records are unreliable, or if the business can’t produce current financial records, any prospective buyer is likely to discount the value of the business because of the uncertainty about its real profitability. It is therefore important that a business maintains reliable records and be able to produce current records at any time.

As mentioned earlier, in looking at profitability, adjustments are commonly made for extraordinary items of income or expense, and for expenses that are discretionary or personal to the owners.

For example, if there are vehicle expenses or travel expenses for the benefit of the owner, they would be added back in determining profit. Therefore, such expenses must be readily identifiable.

The availability of financial analysis of sales by customer, product, and geographic location can also enhance value where the analysis points to a “low profit risk” due to a good mix of customers or a wide product base.

Key factor: profitability

One of the most important factors in determining value is profitability, which is closely related to cash flow. A business with dependable cash flow will also have dependable profitability.

And an increase in profit will generally lead to an increase in sale value.

This does not mean that all businesses with the same level of profitability will be valued at the same amount. Two companies can be equally profitable, even in the same market, but one will have a higher sale value than the other.

How can this be, you might ask, and it is a very good and important question.

Company A’s profitability is closely related to the owner’s personal skills and relationships, while company B’s profitability is based on product pricing, account mix and corporate culture.

In today’s marketplace, company A is probably worth less than company B, despite the same level of profitability. The reason is that with the departure of company A’s owner, it is more likely that profitability will suffer. The owner needs to be able to show the quality and skills of the rest of the staff, the contribution they make to profit, and the lack of reliance on his or her personal efforts.

Thus, while profitability is important, it is the expectation of continued profitability from the business structure itself, rather than from the ability of the present owner, that is most important.

This can come as a surprise to many vending operators who have worked hard to build the profitability of their business, but in doing so have become too personally associated with the profitability.

This is a problem with other professional services businesses as well, where the reputation of the owner is closely associated with the business’ success. The owner needs to reduce his or her influence on the profitability of the business in order to maximize its sale value.

This will include establishing a management team, improving formality of management, introducing customers to others in the business, keeping records of customer contacts, and excluding the owner’s name from the business.

A business that has good management systems, is well located and enjoys a long-standing reputation should be able to maintain its profits. Such a business would usually be said to have a low risk for a new owner.

Because of this low risk, the sale value of the business will be higher than that of a business where there is a high risk that the profit will not be sustained.

If a valuation identifies factors that would put the earning of profits at risk, steps need to be taken to minimize the effect of those factors in order to enhance the value of the business.

Given the myriad of factors that affect the profitability of a vending business, it is easy to see that many businesses offered for sale in the vending industry are not seriously for sale. Owners have nothing to lose, so they “test the waters” to find out about the sale process and see what their business is worth.

Many today are unprepared

As a buyer, I’ve sat through many lunches with these “tire kickers” only to find that they have no intention of parting with their companies. Maybe if they could receive three times what the business is worth they might think about it.

As a seller, if you go through a broker, realize that you have done nothing to signal to the buyer that you are serious about finalizing a deal. In fact, using a broker signals just the opposite.

Assuming you are not a “tire kicker,” you need to do everything in your power to let potential buyers know you are serious about selling. Do your homework, and it will pay off.

Bottom line: Find out what your business is really worth and use the valuation as a tool to improve the bottom line.

Goodwill + tangible assets = Total calculated value

Goodwill is enhanced by improving value through factors such as handing management to others to reduce the owner’s personal association with the business.

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