On a daily basis, most SME owners are not overly concerned with the valuation of their business. Top line sales growth, inventory levels, net profitability, liquid cash flow, and other data and measures that business owners check on a regular basis are probable.
The following are the few instances where business value is no longer an afterthought:
- Selling the company to exit the business
- External investors that purchase stock in the company
- Purchasing shares from shareholders
- Putting together a business loan application
- Offering equity compensation to key personnel
Because SMEs are often unlisted enterprises with no publicly traded business, valuing them can be difficult and subjective, depending on the information used.
There are a few widely accepted methods for determining a business’s value. Three of these will be discussed in further depth below.
Keep in mind that certain industries may regard one valuation approach to be more suited than the others. We’ll go over this in more detail in each of the appraisal methods listed below.
The going concern approach is used in this valuation procedure. The derived business value is calculated by subtracting the net asset value of the business (minus depreciation) from liabilities (such as a SME loan or an outstanding lease).
The computation appears straightforward, but the devil is in the details, and deciding which assets or obligations to include in the assessment is difficult. Furthermore, determining a criterion for assessing their value, as well as the real assets and liabilities value to arrive at the valuation, is difficult.
Another issue is that different organizations’ balance sheets may or may not include intangible assets like proprietary IP rights and brand goodwill, which are vital in determining the business’s worth.
Due to the removal of intangible assets that bring real value to the business, the computed valuation may appear to be undervalued on paper.
Economic Book Value Calculation, Liquidation Value Calculation, and Replacement Cost Valuation are three methods for asset-based valuation.
The accounting book values of assets are updated to their current market value under Economic Book Value, but the Liquidation Value approach uses a projected value of assets at liquidation less the cost of liquidation. The cost of obtaining the identical assets from scratch is used to value assets in the Valuation at Replacement Cost technique.
The asset-based approach to valuation is appropriate for organizations that aren’t particularly operational but rely heavily on capital assets for income or value. Real estate holding firms and heavy mechanical equipment rental businesses are examples.
Valuation of Comparable Transactions
This strategy is commonly employed when valuing a company for the aim of selling it. A peer group is compared using this method using the same standards. Similar companies in the same industry, as well as market capitalization, would be considered as a peer group for valuation purposes.
Following that, the companies are evaluated using popular multiples such as EV/EBITDA, PE ratio, and PEG ratio, among others. To determine the existing and potential worth of a firm, it should be evaluated using multiple criteria.
When there are predetermined benchmarks against which organizations must be measured, things appear simple. However, this strategy has its own set of disadvantages, such as the difficulty of gathering all of the company’s previous data, particularly for private company transactions.
As a result, this method is utilized in conjunction with others rather than alone. To present the fair worth of a business, Comparable Transaction Valuation is frequently used in conjunction with the Discounted Cash Flow approach.
Discounted Cash Flow Method
It is the most widely used method for arriving at a near-perfect appraisal. Because the value of future cash flows is reduced to the present, the word discounting is utilized.
When computing the business valuation, the Discounted Cash Flow approach considers inflation. To determine the current worth, the business’s estimated future cashflow is discounted by the time value of money. Inflation is included into the time value of money.
For example, which offer do you believe is superior: A $1,000 offer is available right now, or $100 every year for the next 12 years. At first glance, $100 for 12 years appears to be the superior option because it results in a total of $1200 after 12 years. However, the rate of inflation is not considered.
Assuming a 5% annual inflation rate, the $100 you may have received next year is now worth $95 today. After 12 years, the value of $100 would be approximately $56. To arrive at a present value, a discount rate is used.
Despite the fact that all of the methods are routinely used to value a small business, Discounted Cash Flow provides the most accurate image of the business.
This strategy provides a more accurate representation of a company’s current value and is more relatable to both investors and business owners. This strategy is appropriate for businesses with strong growth potential but low profitability.
Discounted Cash Flow Method
In order to calculate the value of a business, most companies use a combination of two or more methodologies. ‘Multipliers’ are commonly used on valuations, depending on the industry.
Due to scalability, enterprises in the tech industry, for example, will have a bigger multiplier tied to their valuation than a traditional multi-chain F&B business.
Before a business valuation exercise, SME owners often look to ‘window dress’ their financials. Paying down liabilities, such as the popular SME Working Capital Loan, which has no early redemption penalty, is one viable way to increase valuations. Also, tightening credit collections on accounts receivables while pushing for extended credit terms on trade payables will improve cash flow.
Even if you have no plans to sell your business anytime soon, conducting an annual business valuation to evaluate your business’s paper value and identify growth prospects is recommended.