Valuation Does Not Equal Price - “what Is A Business Really Worth”

It must be stressed that there are no standard methods for valuing a business, there are various possibilities used, but are really no more than a guidance factor.

The main reason for seeking a valuation of a business is so that a purchase price can be ascertained. However, have no doubt that the price eventually paid could be very different from the valuation calculation. In all my experience I have rarely concluded a deal on the valuation given by an auditor or other adviser, whether buying or selling. The seller wants as much as possible, whilst the buyer wants to pay as little as possible.

The reasons for these statements generally centre around the following factors-

• The worth of a business is a function of its profit potential, balanced by the investment required and the risks involved.

• Past profit ability and asset values are a good start, but other matters such as supplier relationships, the intangibles (intellectual property, reputation, branding goodwill, name, and location) can also affect the value.

• It is usually accepted that any price is right as long as the business can pay for itself over a reasonable period of time (usually 2 years) e.g. if the profit is R200,000 per annum, the price times 2 would be R400,000.

• Due diligence investigations may unearth evidence which results in the price being reduced. If serious problems are found the sale becomes a fire sale and is usually sold at the value of the assets less liabilities, if it is worth buying at all.

• The owners/sellers drawings must be taken out of the valuation, usually because they are too high, and give a false impression of the business value.

• The valuation may not be realistic compared with market conditions. If there is strong competition, there may be no guarantee of future success.

• When placing a value on a business much depends upon the bargaining position and negotiating skills of the parties.

• If there are sound synergistic possibilities, a premium may well be paid over and above the calculated value, sometimes called goodwill.

• The valuation exercise may be quite straight forward, but there are many variables and assumptions which can influence the final calculation, such as, future profits, returns, market conditions, existing management and financial structures etc.

• To repeat from other chapters-If the seller’s lowest price is close to the buyer’s highest price there is usually a deal

• Relying on the financial statements alone is looking for trouble, especially for financial statements drawn up by financial advisers for a transaction. NB. The value in the balance sheet for assets is often very different from the market value (and mostly inflated-look at laptops).

• Sellers sometimes want to be paid for all of the hard work that they have put into the business, which is often not realistic. The business is their baby, and they want out with as much as they can get.

• Best known methods of valuation are often not realistic for small businesses.

• The business is only a good investment if it can earn a good return on the price paid.

• Perhaps price is what you eventually pay for a business, and value equates to how desirable or important a business is to the buyer.

Never buy a business because the price is right, be certain that the business itself is right for you.

It must be repeated that there is no single, correct answer to the question of how much a business is worth. There are however, certain criteria common to all business enterprises which enable basic valuation rules to be formulated and applied to businesses in general. Also of importance is the way a business is valued will depend on the category of the business enterprise. There are a lot of differences between a service business and a manufacturing business.

Although a variety of procedures may be used to establish reasonable value, the basic principle is that the value of the business assets is determined by its expected or potential earning power and the degree of risk or uncertainty involved. Ultimately the value of a small business will depend on its profitability, and the ability and capacity to expand that profitability.

Investors and other interested parties are attracted to enterprises which have a stable cash flow history and show good prospects in respect of future earnings.

It must therefore be noted that the real value of a going concern business lies in its future earnings rather than past earnings.

At a seminar I attended a few years ago, 15 of us were given the exact information (financials) etc on a mock business, and asked to value it, and we came up with 15 different valuations.

A mentor of mine many years ago, ( I believe that what he said is true today) advised me “There is no correct method for valuing a business-, due diligence, negotiation experience, judgment, ‘business nose’ and horse-trading skills all have an important impact on the final outcome”.

At the end of the day a business is worth what a buyer is prepared to pay and a seller prepared to accept.

Bob Power

Corporate Consultants

www.powerconsulting.co.za