Small Business Valuation Methods – Review

Below we’ll review the main methods of small business valuation and conclude with some personal observations and approach that appears lacking with the more ‘academic’ and less ‘street wise’ analysis.

A small business for the purposes of this review is assumed as a business that is largely run by a principal owner with a limited number of staff. Generally, with a turnover of less than a million per annum.

The valuation methods generally used are:

  • Book Value

  • Cash flow method

  • Price / Earnings method

Book Value

This is simply the value of net assets (Total Assets less Total Liabilities). It is simple to calculate and observe.

The primary issue with this method is that if a business is worth the assets less the liabilities, then why buy the business? Just simply set up a new business and buy the appropriate assets to facilitate operations.

Hence, the net asset book value approach is more suited to businesses that have ceased operations and the buyer is simply looking to acquire the assets without any pipeline of sales, goodwill, processes, trained staff etc.

Another issue with the net asset basis is that the amounts recorded in the balance sheet are not necessarily aligned with market value or productive economic value. As an example, a piece of industrial machinery after a decade will likely be shown in the fixed asset registered as having a net value of $1 (Assets are kept on the balance sheet until they are disposed/scrapped or sold) even though it is still in productive use within the business.

An additional example would be a significant recent investment in the business equipment/assets that will start to deliver increased profits going forward greater than the cost of those assets (Say in a landscaping business there has been a significant scale up in equipment that has been purchased on credit, it won’t increase net assets (Assets less the liability) but will enable greater revenues through new sales and cross selling additional services to an established client base.

Hence, while the market value of net assets is not necessarily the best valuation basis in a going concern, it does help a buyer de-risk (Mitigate) the acquisition given that there is a residual asset value that could be realized in the case of the business failing. However, adequate consideration needs to be considered whether those assets can be realized ultimately for more than pennies on the dollar. As an example, a commercial kitchen by the time it is stripped out, is likely to obtain 10% of its going concern market value.

Cashflow model

This method considers the cash generating ability of the business. Logically a business is worth the net cashflows it can generate over time. In this context it is a better indicator of business value than simply looking at the net asset value in the previous section.

The buyer of any business will generally take the position of paying for the ‘comfort’ of observable past performance while assuming future performance is a function of their own abilities and input. The seller of any business will generally want the sales price to take into consideration the future performance of the business.

Hence, any cashflow assessment will likely entail producing historical and projected cashflows to facilitate negotiations. Normally these statements are for the prior and future 3 financial years.

From these time series of cashflows an average, weighted average is used as a basis with a multiplier to come to an appropriate Value.

Some additional points

  • Owners remuneration is generally stripped out of the cashflow, along with any finance costs.

  • A reconciliation between cashflows and the income statement (Profit & Loss) should be undertaken for prior years and any assumptions and expectations should be clearly documented with future years cashflow forecasts.

  • Cashflows incorporate inflation changes over time and prior/expected economic conditions.

  • Often there is a desire to discount future cashflows by the cost of capital, however the flip side is that historical cashflows are additionally impacted so they equally should be subject to correction / restatement to the current period.

Hence, the basis of valuation is ultimately more art than science. There is subjectivity over which cashflows to use and what to exclude/include and the resultant multiplier used to gross up to a transactional valuation that is acceptable to both buyer and seller.

Ultimately the overarching logic should result in acceptance of what is the most likely (probabilistic) cashflows attributable to the sellers previous actions and investment, with an attached multiplier that is related and relative to other similar industry business sales of a similar size/scale in current economic climate.

Price / Earnings Method

This is a variation on the Cashflow model except it utilizes the earnings of the business rather than the Cashflows. Once the appropriate earnings of the business are decided on it is simply grossed up by a multiple (multiplier) to come to a valuation of the business.

The multiplier as with the Cashflow model is taken from reference to similar types and sizes of businesses in the current economic climate.

Generally, as a rule of thumb a multiplier of around 3 is applied to a small business. If you look at stock market tables you’ll see large listed companies trading with multiples as high as 100. There are a whole host of reasons for this including aspects such as passive investment rather than active management (Of you, the investor), liquidity of share/ownership sales, professional management, scale, diversification and so forth.

Note: Many of the additional points highlighted in the cashflow assessment basis apply also, especially the reversing out of Owners compensation and Financing costs.

Overview Summary

In conclusion there is no set valuation basis, however, a cashflow analysis with a bridge between the profit and loss basis to the cashflows should give a reasonable insight, with audit (Due diligence) of the financials to give confidence in their accuracy/legitimacy. An article on this site about that aspect here .

Any valuation should sit within the normal range of business valuations unless there are some additional features (Such as a distressed sale or some significant benefit to the acquirer) that is inherent in the transaction.

In theory the absolute baseline value should be the net realizable value of net assets, with a range to the highest valuation that the buyer may have, given additional benefits not currently being achieved in the business (Such as say synergies to be gained on a complementary or similar business, In this case a buyer should always undertake their own (Internal Management) valuation of net benefits arising from the acquisition so they are aware of the absolute maximum the transaction is worth).

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