Understanding the value of your Business: Part 1

In this three part article series, our Valuations Lead Partner Nicole Vignaroli, unpacks the key areas that are often overlooked and/or misunderstood when considering your business’ value.

When you own a small or medium enterprise (SME), you’re often close to the operations of the business, understand key value drivers, and are intimately involved with the activities and financial performance. However, it is not uncommon for business owners (or their non-valuation qualified advisers/ accountant) to view the business in an overly positive manner. When this view is applied to a valuation analysis it can lead to valuation outcomes that can be contrary to, and widely disparate with, the true underlying market value of the business.

It is vitally important for business owners to consider the below points when working towards a valuation, in order to avoid a disparity between an owner’s perception of value and the actual underlying market value of a business.

Definition of value:

First, we revisit the commonly adopted definition of market value, which underlies the preparation of a valuation. Whilst the following definitions refer to tax and accounting purposes, they are commonly applied as the premise for the definition of value for other commercial purposes also.

Although tax law doesn’t specifically define market value, it usually takes on the following definition: “the price that would be negotiated in an open and unrestricted market between a knowledgeable and willing, but not anxious buyer, and a knowledgeable and willing, but not anxious seller, acting at arm’s length.”

Similarly, the concept of fair value for accounting purposes as defined under Australian Accounting Standards Board 13 Fair Value Measurement, being “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Common issues in (SME) valuations:

Outlined below are common factors either overlooked or not properly understood when undertaking a valuation, and are therefore not accurately adjusted for, or appropriately incorporated into a (current date) valuation analysis:

1. Normalisation adjustments

It is not uncommon for business owners to refrain from ensuring they (and other family members) are remunerated at market rates. Similarly, any long-standing agreements relating to rental agreements and/or freehold premises ownership may not represent what could be achieved in the market today. Making appropriate adjustments to the business’ historical and forecast earnings for required normalisations can have material impact to the underlying reported and prospective financial performance.

2. Profitability and scalability

Business owners often assume that the business is highly profitable and scalable, and able to achieve economies of scale and/or growth synergies. As discussed above, seemingly profitable operations may not be an accurate reflection of true performance (post normalisation adjustments). Further, depending on the business activities, market dynamics and industry specific risks, not all operations are able to achieve economies of scale to the extent of, and within the timeframes envisaged. Valuers need to critically scrutinise and objectively consider all information available.

3. Forecasting error and budgeting convention

The art of forecasting and preparing budgets can vary widely and can range from a detailed bottom-up process, to a high-level estimate based on a growth factor applied to the prior year’s result. Notwithstanding the process adopted, it is not uncommon to observe forecasting error and the margin of error should be considered over time, to inform more accurate forecasting in the future.

In addition, in-house budgeting convention should also be understood when utilising cash flows for the purpose of a valuation. Are budget stretch targets aimed at over achievement (and potentially unattainable)? Or conversely, are ‘soft’ targets structured to be easily achieved hurdles? Consistent with the definition of value (noted above), cash flows used for a valuation should represent reasonably ‘expected’ cash flows of a business and not be overly optimistic or pessimistic, but present a balanced and expected view of the cash flows to be generated.

We can help

Determining an accurate valuation is complex and many critical issues are often overlooked by business owners (or their non-valuation qualified advisers/ accountant) attempting to determine the valuation of the business. The failure to fully understand and incorporate all aspects of an appropriate valuation can result in significant variation to a reasonable range of the underlying market value of an entity. At Findex we know rigorous and independent valuations are essential prerequisites for sound business decisions. Through startup, expansion and continued progress, and by applying professional care and a wealth of experience, we support small and medium enterprises of all shapes throughout Australia.

If you require valuation advice, and comfort in ensuring accurate valuation outcomes, we are here to assist. Our skilled team has extensive Corporate Finance experience across a wide range of sectors. The key to our involvement is adopting an integrated approach. We understand that value is driven by risk and return, and that perceptions about each can vary. Each business is unique, and each has different underlying factors that drive and impact value.

You can rest assured we have the depth of experience to assist, and take a nimble and commercial approach, managing various stakeholders and tailoring our solution to suit your needs.

If you require further assistance, please contact your Findex adviser.