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Waddle

What’s my business worth? How valuations work

Learn about two business valuation methods.

Team WaddleTeam Waddle

You’ve romanticised about the valuation of your business before, everyone has at some stage.

There are times in the business lifecycle when valuing your business needs to be more than a fleeting thought experiment, e.g. capital raising, investments, divestures and sale. Business valuation is a deep and complex topic performed by people with sound knowledge in financial theory. The business owner is not expected to be skilled in this area however there are concepts the business owner should understand in order to assist them in conversations and drive their desired outcome (likely a higher valuation). First some base cases…

For a business that is not considered to be a going concern, the logical valuation is the Net Asset Value of the company. Simply calculate the total market value of assets (inventory, equipment, accounts receivable, cash balances etc) and subtract any debt owed. There you have your valuation.

Consider another business that is a going concern however is expected to not generate future profits. It is useful to calculate the Net Asset Value of the company and consider this to be a maximum valuation. A business that is not expected to generate future profits logically should have a valuation less than its Net Asset Value. (Conversely for a business that is expected to generate future profits the Net Asset Value should be considered the minimum valuation)

Now for businesses that are expected to be profitable, here are two broad tools in the valuation toolbox :

Discounted Cash Flow (DCF) Valuation

Considered the ‘gold standard’ in financial circles and literature. It is the method likely to be utilized when engaging an investment bank for valuation services. The process involves forecasting future free cash flows of the business and discounting them at a suitable risk adjusted interest rate. Straight away you can see this is not an exact science with the process full of subjectivity. How confident can you be forecasting next years cash flow let alone cash flow in 5 years time? DCF valuations are complex, require skill, take time and it is for this reason that they are often passed up for quicker and simpler tools such as the relative valuation.

Relative Valuation

In relative valuation, the value of a business is compared to the values assessed by the market for similar businesses. One type of relative valuation that you have likely heard used for public companies is the P/E ratio. It’s quite simple – divide current stock price by earnings per share to give you the P/E ratio. As an example, currently JB Hi-Fi has a P/E Ratio of 13. If you are running a retail business similar to JB Hi-Fi it may be a logical starting point to take JB Hi-Fi’s multiple and apply it to your Net Profit (earnings) to devise your valuation. This is just a starting point however as it’s unlikely your business has business fundamentals that match JB Hi-Fi. The following are just some of the factors to consider for your business that give cause to a higher or lower multiple valuation:

You’re unlikely to be a valuation expert, however with an understanding of the process it is easy to see the importance of describing the value drivers of your business as it directly effects the end valuation. Telling the story of why your business is so great is as important as crunching the numbers. Luckily most business owners are pretty good at doing that.

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