WHAT ARE YOU WORTH? Top 5 tips for a business valuation
Valuation is a complicated and rather intimidating topic for most small or medium business. To this end, du’s John Lincoln gives you 5 top tips to keep in mind for a valuation exercise.
June 18, 2012 3:54 by kippreport
What is your business worth? It is a tricky question for sure, but it is one worth asking. Understanding how a business is valued will help small business owners and investors in SMEs to develop strategies and tactics to maximize the variables that matter. And remember, valuation is an exercise necessary not just for selling a business; a valuation exercise can also help in investment. Of course, there is no single best method to determine a business’s worth. The best way is to compute the value using different methods and choose the best one. You can always get an expert opinion, but at the end of the day, you have to make the decision.
Every business valuation follows some basic principles that you should always keep in mind.
- Every business is valued based on its growth potential. Growth is fundamental for any business. Without a growth potential, there is really no reason for anyone to invest or buy a business.
- Remember that the business investment capital comes from 2 sources. By investors investing money in the business and from borrowings. Therefore there is a cost of capital. One is the opportunity cost of returns forgone from other investments, and the other is the actual cost of borrowing.
- As a business owner, the profits generated from your company can be reinvested to grow the business, pay off your debt or reward your investors with dividends. You and the investors in your business or the potential buyers of your business can invest their money somewhere else or in the stock market and can expect some reasonable returns.
- There is a time value of money. A $1,000 paid at end of 5 years is not the same as if it is paid today, because if you had made some safe investments in the market or put the money in the bank, you can expect some level of reasonable returns.
- You may not know this, but for almost all public companies, only about less than 10 percent of the market capitalization can be explained from the expected cash flows generated during a known planning period of say, 5 years. Trying to predict anything beyond a 5 or a 10 year business plan time horizon has too many uncertainties and is not worth the paper it is printed on. So analysts use the growth factor to forecast the terminal value or the continuing value of the business. This terminal value or continuing value accounts for about 95% of a company’s market capitalization. If you do not believe me, take a look at some of the largest and well known businesses in the world. Their revenue numbers are well known and reported and it is easy for you to check this.