If you haven’t already worked this out there may come a time – when selling, merging or seeking investment in your business – that you will need to. So what’s the answer?
From a financial perspective there are a few techniques you can use to calculate the value of your business:
Discounted cash flow
This is the most technical method but provided you assess the information correctly it will give you the most accurate view. This method works on the premise that a buyer is investing in the future profits of the business.
To calculate a value you would forecast the financial inflows (income) and outflows (costs) of the business over the next three to five years. Those net future cash flows are discounted to today’s value. This works on the principle that $100 today is worth more than $100 in a year’s time.
The amount you discount by depends on the rate of return a buyer might want, for example 15 per cent. In order to get this rate of return you would look at “safe” returns that a buyer could get, for example from term deposits, and riskier returns that they might get from investing in shares. In order for a buyer to want to invest $100,000 today they would need to know that the net future cash inflows represented at least a return of that 15 per cent.
Revenue or profit multiples
This is the simplest method, but the trick lies in picking the right multiple. Using this method your current year revenue or profit is multiplied by a factor common to similar businesses in your industry.
This method is often referenced when looking at listed businesses where their market capitalisation (share price multiplied by number of shares) is compared with their revenue or profit. Valuing your business works on the same principal.
The type of business and industry is critical to picking the right multiple. A services-based business may be valued on as little as one times revenue because there is little regular or repeat business. Conversely a retail or subscription-type business could be based on 5–10 times revenue, as income is steadier and can be locked in though contracts.
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This is the absolute minimum your business is worth. Your total assets (cash in the bank, stock, debtors and equipment) are added together and then your total liabilities (debts to suppliers and loans) are deducted.
This method doesn’t take into account the future earnings of the business or any of the goodwill or intangible assets your business has generated during the course of its life. Goodwill can be created from your physical location or your business relationship with suppliers and intangible assets from trade marks or intellectual property that you own. Therefore pure asset value is very likely to undervalue your business and would be the absolute floor price you would accept.
Cost to create
How much would it cost a potential buyer to build the business themselves? The theory is that they would pay this much plus a convenience premium to buy a ready-made business.
Your customers, relationships with suppliers and reputation in the industry are assets you have built up over the life of your business. Time is money and a buyer would pay a premium to skip the effort it took you to do this.
Quantifying the value here is very subjective and depends on the buyer.
Look around at what price similar businesses have been able to achieve. This information can be hard to find but sources include brokers, industry publications or classified sections in newspapers or websites.
Ultimately your business is only worth what a buyer is prepared to pay for it and that’s why valuing a business is more of an art that a science. However, calculating a range of values based on the methods above will give you confidence to negotiate with potential buyers.
What are your tips for calculating the value of your business?
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