18 Apr Understanding Business Value
If someone asked you the question – “How do you value a business?” what would you say? There are a number of ways to look at value. Someone may say – the real value of the business is what it gives me – the lifestyle, being my own boss, determining my own outcome in life, being able to establish my income and so forth. Another person might say looking at the financials one can work out the net worth of the enterprise. As many people as you could ask that is the number of interpretations that I believe you would get.
Breaking it down in a simple way one can look at a business through the eyes of the worth to the owner – the intangibles, and the value of what the business has – the tangibles. Looking at these we can break them down a little more.
Intangibles cover aspects of the business covered by the word most often heard the goodwill of the company. This is what is contained within the company in the people, their skills and abilities. In addition it may also embody things such as brand status, technical intellectual knowledge or know how, systems or abilities of the company as a whole. One further aspect that is important under the intangibles are the key relationships that may exist between the company and its customers or suppliers. Agreements especially written ones can add a great deal of value to the business and lessen the risk discussed under the unit “Buying a Business.” The risk is lessened by having committed orders or guaranteed supply arrangements. Generally these intangibles do not have a value on the balance sheet – however some brands or business trademarks may.
Tangible value is got from ownership of the building, improvement to the property and the plant, fixtures and fittings that the company has. These are the “hard assets.” These assets are depreciable and have a value on the balance sheet.
When establishing a value for the business one can get it from either considering the goodwill or by looking at the assets or through a combination of both. Let’s take the situation where the sale price of a business is calculated merely from the intangibles.
Typically in the marketplace this is done by calculating the discretionary net income or cash surplus to the owner and then applying a multiple to it. The multiple is arrived at in the marketplace. Business brokers have access to national statistics and to their peers who are actively selling similar businesses every day. These numbers indicate what the market is likely to pay for any type of business. When posting this value although the business sale price has been calculated in this fashion the market will only pay what this number can bear. In other words – what is the real value behind this number. No one is going to pay an inordinate amount for a business that does not stack up. The test – what is the risk versus the return on investment. Generally the greater the intangibles the higher the risk.
When we calculate the sale price from the tangibles we look at their value in the financial records. This is the current depreciated value. Often the business owner would like to get more for their business because they know the replacement value is more than the depreciated value. In this instance a combination of tangibles and intangibles may be used. It must however be remembered that the business owner has benefitted from the tax reductions gained via the write back of depreciation.
When a mixture of tangibles and intangibles is used there is no multiple used for the intangibles. Doing so puts the price of the business too high and out of the market acceptability. The greater the percentage of tangibles to intangibles the lesser the risk. In this instance if the venture were to fail the owner could realise some funds by selling off the assets.
When looking at returns of investment the higher the tangibles the lower the risk. As a percentage high asset bases typically demand a return of a minimum of 25%. High intangibles require a minimum return of up to 45%, even 50% in some instances. Whatever way a business is valued the ultimate determination comes – what will the market pay for such a business? This is tempered by sustainability of the business as a whole. E.g. the value may be fair but the product is no longer selling in the market. Despite the correct price being calculated the business can no longer maintain its sales.
On occasions business owners want a higher price for their businesses because they have good growth plans in place. This does not translate into the sale price because they have not been realised. What it does do – it makes the business more desirable to the buyer. There is excitement and a keenness to buy because the buyer can visual added profits in the short term.
The seller always wants more and the buyer the opposite – they are trying to buy for the cheapest price possible. In reality, if the business price stacks up it will get the market value. At the outset it is better to work with your broker to establish this realistic price. Failed expectations lead to frustration and disappointment. Unrealistic prices do not lead to a win:win situation.