One of the most common questions business owners ask is simple: how do you actually work out what a business is worth? There is rarely one number that can be pulled directly from the financial statements. A business valuation usually involves analysing the financial performance of the business, determining an appropriate level of maintainable earnings, considering the risks attached to those earnings and applying a valuation methodology that makes sense for the business and its industry. That is why two businesses with similar revenue can ultimately receive very different valuations, and why relying on one simple formula can often produce a misleading result.
It usually starts with the financials
Historical financial performance provides an important foundation for a valuation. Revenue, profitability, margins, expenses and earnings trends can all help establish how the business has performed over time. One year in isolation rarely tells the whole story, so a valuer may look across several years to determine whether recent performance is representative of the business or whether there have been unusual increases, declines or one-off events. The objective is not simply to record what the business earned last year, but to understand what level of earnings the business can reasonably be expected to maintain going forward.
The earnings may need to be normalised
Privately owned businesses often contain expenses or income that would not necessarily continue under new ownership. This is where normalisation adjustments, sometimes referred to as add-backs, can become relevant. There may be genuine one-off expenses, owner-related costs or other items that need to be adjusted to better represent the underlying performance of the business. However, those adjustments need to be supportable. Removing expenses simply because they reduce profit does not create a higher legitimate valuation. The aim is to arrive at a realistic maintainable earnings figure that reflects how the business is actually expected to perform.
The valuation method matters
Different businesses may be valued using different approaches. For many established small and medium businesses, an earnings-based methodology may be appropriate, which can involve applying a valuation multiple to an adjusted earnings figure. Other circumstances may require consideration of assets, future cash flows or other valuation approaches. The methodology needs to suit the nature of the business rather than being selected simply because it produces the most attractive number. A good valuation should be able to explain why a particular approach was used and why it is appropriate.
The multiple reflects more than the industry
Once maintainable earnings have been established, selecting an appropriate multiple is another important part of the valuation. Industry evidence can provide guidance, but businesses within the same industry are not identical. A business with diversified customers, recurring revenue, strong management and limited owner dependency may carry a different level of risk from another business in the same sector with concentrated revenue and significant reliance on the owner. Those differences can influence the multiple applied and ultimately the valuation itself.
A useful business valuation is not simply revenue multiplied by an industry percentage or profit multiplied by a number found online. It brings together financial performance, maintainable earnings, risk, market evidence and the characteristics of the individual business. The final valuation should therefore be supported by a clear explanation of how the number was reached. Knowing the value is useful, but understanding what sits behind that value can be even more useful.
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Regards,
Tony Arena