If you think the answer is “X times earnings”, this article is for you.
For owners, the question of business value may come up if it’s time to sell, if there is a divorce, if a partner wants to exit the business, or if a valuation is required by CRA.
Business value depends on many factors and there is an element of subjectivity to any conclusion on value. Further, value is usually different than the sale price of a business. Why? Because sale price is a function of worth to a particular purchaser and is subject to negotiation. When a business is not for sale to a third party, value typically considers only the fundamentals of the business on a standalone basis.
Factors that Impact Value
Often, we look to the future when assessing value. A company’s prospects and likelihood of achieving success are core components of value.
Many factors can influence future prospects and some of these are below. One big caveat when you read this; business valuation is complex and these points have been greatly simplified.
Cash is the bottom line of business success. High cash flow positively influences value.
If your business has a history of solid performance with no major changes in site, it could be seen as less risky and this is accretive to value. Now let’s consider a business that has had three years of strong earnings growth. Because of their success, competition is ramping up. The risk that the company won’t be able to replicate past results is increasing and this could negatively affect value.
All kinds of industry factors can influence salability and value. Consider if your industry is growing or in decline, whether it faces increasing government regulation or supply risks and how competitive it is.
The balance sheet tells a lot about company strength. It is the basis for assessing liquidity, asset backing and the company’s performance compared to industry norms. A strong business that outperforms its competitors could have a higher relative value.
Reliance on you
Suppose you are an expert at manufacturing widgets and you operate a business where you conduct speaking engagements and write articles about widget manufacturing. It’s pretty clear that your business isn’t worth much if you are no longer a part of it. Now consider that you apply your expertise to operating a widget manufacturing business. You have put the right people in place and imparted your skills so that you can go south all winter. Not only might this business be attractive to a buyer because it is an expertly executed operation, but also because they could step in as an owner and the operations would not be disrupted.
X Time Earnings
Well, this might be a factor in assessing value after all. It’s called a Rule of Thumb and, while we wouldn’t determine value on this basis alone, it can be used as a smell test to see if our hard fought for value determination is reasonable. Of course, all Rules of Thumb are not created equal. If the business is in an industry with many comparable documented sale transactions, this is a more reliable indicator than if, say, your cousin Jimmy’s friend told him that businesses just like yours sell for 3 times earnings (by the way is that pre-tax or after tax earnings?)
Price is Different than Value
When deciding what they are willing to pay, buyers will look at a business in terms of their particular expected benefits and the risk associated with achieving them. This may well lead them to a different conclusion than the value determined for the business as a standalone entity.
Buyers have different reasons for acquiring a business, such as:
- To take out a competitor and increase market share
- To gain entry in a new geography
- To expand product offerings or give the buyer a more robust vertical
- To acquire better processes, equipment or technology than what they already have.
- To buy themselves a job
Suppose there are two buyers looking at a business. The first is a competitor who thinks that combining entities will result in efficiencies and increased purchasing power, yielding higher earnings for both companies. This buyer could pay a premium over the target’s standalone value and still make a great return.
The second buyer is an industry executive who now wants to be their own boss. This buyer might see value in not having to start from scratch, and may feel that they can operate the business better than the current owners. They might be willing to pay more than standalone value for the business, but the premium may be different than that of the first buyer.
Now let’s suppose that there is only one buyer. Regardless of the potential benefits they might expect from acquiring the business, they may not be willing to pay any more than standalone value because they don’t have to.
Always use a Professional Business Valuator
Business valuation and pricing mistakes are costly and DIY is not recommended. Regardless of the reason for valuation, you should always consult a Chartered Business Valuator before proceeding.
Want to learn more?
Please contact Compass Accounting for more information on our valuation services.