Understanding the value of your Business: Part 2

7 February 2020

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.

See the first article in the series here.

As outlined in article one, several key factors must be independently considered when working towards valuing a business. Although a business owner will often have intimate knowledge of the business operations and strategies, this does not necessarily correlate with an accurate understanding of the business’ value. Here are four further matters to consider when understanding the value of your business.

1. Dependency on key customers and markets

SMEs often have stable and long-standing relationships with key customers and target markets which may have been established during the business’ formative years. Whilst these customers and markets underlie the stability of the business and generation of revenue, a dependency on a few key customers and markets can also present a critical business risk. If the potential loss of certain key customers or markets would have a material impact on cash flows and earnings, these risks should be appropriately factored into the valuation analysis.

2. Key person risk

Founders of SME businesses are often passionate and the driving force behind the growth and success of the business. They often have close relationships with multiple stakeholders including customers, suppliers, alliance partners and employees, which have necessarily developed as the business has grown. In addition, key individuals within the business are the key originators of business opportunities, the converters of sales, the executors of the work, and are informed around all elements of the business operations and processes. These individuals represent a critical ‘cog’ in the wheels of success, yet they also represent a major risk should anything occur that would divert their energy away from the business. Consequently, any risks associated with the loss or reduced activity of key individuals should be appropriately factored into the valuation analysis.

3. Applicable earnings multiples

Firstly, it is typical for business owners to adopt the widely recognised capitalisation of future maintainable earnings (“FME”) approach to a valuation. Caution should be taken, as this approach is not always applicable to the circumstances, and other more appropriate valuation methodologies may be better suited to the subject entity to be valued.

Notwithstanding, when adopting the FME approach to a valuation, it is typical for business owners to use market rumours and rule of thumb earnings multiples as an input source for their own valuation calculations. A few overlooked realities include:

  • Does the multiple relate to the right level of earning? An EBIT multiple can be very different to an EBITDA multiple, which is also not comparable to a Revenue multiple, and so on;
  • A multiple achieved in one transaction is not necessarily applicable to the subject entity being valued. Adjustments must be incorporated to allow for differences in maturity profile of the business, market position and share, size, diversification of products/services, historical performance, track-record and length of time since establishment, expected forecasts, profitability and margins, etc.;
  • Matching the correct multiple with the correct adopted earnings from a time perspective. If the adopted FME represents a forecast view of the business, then similarly the multiple should also represent a forecast multiple (and vice-versa, historical FME should be consistently applied to historical based earnings multiples); and
  • The multiple data should be relatively contemporaneous.

4. Surplus assets

Surplus assets (or liabilities) are defined as assets that do not contribute to the activities and cash flows of the business operations, and are therefore considered to be in excess of business requirements. Without these assets, the business would continue to function as expected. These assets and/or liabilities can take the form of idle properties, personal motor vehicles, excess cash or working capital, investments outside of the core operations of the business, etc. and must be adjusted to derive an accurate equity value. In addition, any flow-on adjustments to the cash flows of the business also needs to be appropriately captured.

We can help

As highlighted above, 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 require 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.