One option for the entrepreneur to finance his business is equity finance. This type of finance is where an entrepreneur would sell some share in his business. In order to sell shares a valuation of the business must take place. There are many valuation methods and many of them take into account industry norm when the value of the business is to be determined. Generally, however there are 4 high-level valuation approaches used when dealing with SMEs.
Asset approach – determines value by estimating the value of the businesses assets
Income approach – determines the value of a business by estimating future earning
Goodwill approach – determine the value by including the intangible assets in a business
Hybrid approach – a combination of some of the valuations elements
Asset approach
If you have a stable asset intensive business like property or manufacturing this approach is better suited to the business. However please note this method does not take into account future earnings and goodwill. Essentially with this approach you add up all your assets and minus your liabilities. It is often called book value or Net Asset Value (NAV).
Let’s take for example
| Assets | Liabilities | ||
|---|---|---|---|
| Total assets | 400 | Total liabilities | 95 |
| Cash | 50 | Accounts payable | 20 |
| Account receivable | 70 | Loans | 60 |
| Inventory | 80 | Provisions | 15 |
| Fixed assets | 200 | ||
Asset valuation for this company would be 400 – 95 = 305
We have already noted that the asset valuation does not taken in account future earnings and goodwill but also beware of the true market value of fixed assets, unrecorded assets within the business, depreciation policy and the not fully accounted provisions like leave, holiday pay etc.
Generally, as a rule of thumb asset valuation can be seen as the bare minimum value of the business.
Income approach
If your business is mature where past performance has been well recorded and future prediction of income can be made with a reasonable level of confidence, then this approach is well suited.
There are two dominant methods, multiples and discounted cash flows
Multiples
Basically the value of the company is determined by multiplying an income statement amount for example sales or net income with a multiple. The multiple is determined usually by industry and market norms. As an example the net income multiple is called the price earning multiple and for small business the range could be as varied between 1 and 10. The price earning multiple takes into account macro and micro economics risk.
Net income : 400
Price earning ratio : 3
Value of business : 400 x 3 = 1200
Common practices
In our above example Net profit is used, however this is not generally used. What is used is called maintainable earnings.
Maintainable earnings are regularised and normalised earnings.
Regularising the earnings is the process of adjusting earnings for any factors that distort the earnings from being a true reflection of the business. One should take into consideration
- Accounting treatments
- Owners remuneration
- Taxation outcomes
- Non-core expenses
- Related party transactions
Normalising the earnings is the process of smoothing the earnings over time, thereby taking into account once off events that may have occurred.
The price earning multiple takes into account macro and micro economics risk such as
- Regulatory
- Currency
- Environmental
- Liquidity
- Access to finance
- Interest rates
- Economies of scale
- Industry changes
- Technology
- Competitive pressure
- Alternatives to products/ services
- Business model
Generally in the SME market This multiple is not calculated but rather determined by identifying a comparable business’s multiple and adjusting it if necessary.
Discounted cash flows
This method is a highly technical and usually not used when calculating a valuation for a SME. At a high level it seeks to calculate the valuation by estimating the free cash flows in the future and then discounting them at a discount rate to determine the price today.
Goodwill approach
Broadly speaking, goodwill is the value that a company has above its book value. Goodwill seeks to represent the value of the company’s intangible assets. Which often do not appear on the balance sheet but however contribute to an advantage with respect to the other companies operating in the same industry. The intangible nature of goodwill makes it difficult to value.
Before calculating a value for goodwill, it is necessary to understand the different types of goodwill that may exists in a business. Different types of goodwill have different values.
Personal goodwill
Personal goodwill exists in the business where the owners have personal followings of customers. Common examples include hairdressers, restaurants and professional practices.
The risk with these businesses that if sold customers may leave. Assigning value to personal goodwill should be carefully considered. When personal goodwill is found in the businesses The buyer and seller could agree that there is a transitionary period at the time of sale, The seller agrees a restriction of the same trade in the same locale for a period of time or alternatively There is a claw-back clause in the sale agreement if certain revenue targets are not met.
Corporate goodwill
Corporate goodwill is attached to the business independent of the owners. Examples of such businesses are retailers, manufacturers and wholesalers.
The nature of its business through its strategy, specific rights, brands, reputation and technologies allows the business loyal customers.
Location goodwill
The success of the business is determined by the location, either the visibility, accessibility to customers or the structural specially purposed building provides an advantage. Example of such businesses include convenience stores, hotels and nurseries.
Factors that affect Location goodwill are the lease of the remaining lease, the ability to transfer and extend the lease and business zoning laws
Calculation
The are many ways to calculate goodwill, one way, given the subjectivity is to agree on how much of the revenue is attributed to each of the different types of goodwill and then agree how long that goodwill will create an advantage and how long it will reasonable last. Multiple the two, repeat for all types of goodwill and the sum the total.
Goodwill = Revenue contribution * Probability on maintaining revenue at sale * Duration of advantage
Ex. Revenue: R 1000 for the year
| Type of goodwill | Revenue contribution | Probability on maintaining revenue at sale | Duration of advantage | Value |
|---|---|---|---|---|
| Total | 320 | 819 | ||
| Personal | 50 | 60% | 1 | 30 |
| Corporate | 70 | 90% | 3 | 189 |
| Location | 200 | 100% | 3 | 600 |
In this above example the value of goodwill in this example is R 819
Hybrid approach
One of the most common hybrid method is to use to value a business is to use the multiple of future maintainable earnings method.
This method is calculated as
Value = (maintainable earnings * multiple) + surplus assets
Surplus assets represent any asset held by the business that is not core to the current operation of the business
Another common method and perhaps easy to understand, is calculated by adding the goodwill to the book value.