Profitability & Business valuation
The process of determining the economic value of a business or company is business valuation. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership and split proceedings. Often times, owners will turn to professional business valuators for an objective estimate of the business value.
The process of valuation of business:
The process encompasses different valuation tools and techniques, which are adopted /used by the values to determine the price at which the business will be ultimately bought and sold. There may be other purposes for a business valuation including appraising the value in case of taxation disputes, determining value of partners’ shares etc.
Valuation Analyst
The task of valuation is generally assigned to a valuation analyst who carries out the detailed valuation procedure. It is important for the professional valuer to be well versed with all business valuation methodologies. Understanding the reasons for business valuation and the circumstances surrounding the business valuation are essential before commencing the process of valuation. The business value standards are the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as going concern concept.
Valuing a business based on sales
In some industries, the norm is to determine value by using a multiplier times the firm’s annual sales. Consulting firms, radio stations, temp agencies, PR or ad agencies, professional practices, retailers and insurance brokers are often valued using a multiplier of annual sales. The multiplier depends on the exact type of business, the predictability of sales from year to year and many other factors. Generally, the industry multiplier is the starting point and is then adjusted based on specifics of the company.
Valuing a company using cash flow or profits
The price is based on the company’s ability to generate a stream of profit (which can be defined in different ways) or cash flow (sales less expenses). The seller then projects this stream of cash over five or more years to calculate the worth of the business. Often, discounted future earnings are used which takes into account the time value of money – cash received in year five is discounted based on projected interest rates.
Valuing a company based on assets
Many businesses are sold under less-than-ideal conditions. In the case of crises assets may be used to value the business. The value of the tangible assets usually sets a rock-bottom selling price for the business. Intangible assets may be worth money too – goodwill, customer lists, trademarks, patents, leases, permits and contracts are all intangible assets that can be factored into the price. Many buyers balk at paying a lot for intangibles, but for the seller it pays to evaluate each one for its worth. Hiring an appraiser is often a good idea when the price of a business will be based largely on assets rather than cash flow.
Proper Financial statements and tax returns
Well-documented financial statements and tax returns are essential to demonstrate the business earning power.
Written business operating procedures
Detailed written business operating procedures make it easy to understand how the business works, who does what, and what skills are required.
Well organized business
Since it is easier to take over a well-organized business, there is higher business buyer interest and competition among them tends to increase the business selling price.
Marketing Plan
A good marketing plan provides the essential inputs into the future business earnings projections. And accurate earnings projections are the key to establishing the business value based on its income.
Financial Analysis
The valuation analyst undertakes ratio analysis, (liquidity, turnover, profitability, leverage etc.), trend analysis and industry comparative analysis. The financial analysis is done horizontally as well as vertically. Horizontal analysis means comparing the financial data of the business enterprise and the industry over the past years to determine a trend. Vertical Analysis is a method by which the financial data within a year is compared and analyzed. By comparing a company’s financial statements in different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in capital structure, or other financial trends.
EBITDA Multiples:
EBITDA stands for Earnings before Interest Taxes Depreciation and Amortization, and it’s a fancy way to say untaxed and un-adjusted profits. Once you have this amount calculated in a standard way, you can factor in the cost of outstanding debts to ascertain enterprise value and then also look at which multiples are used for other companies in the industry to determine equity value. As a multiples method, the total calculated enterprise value is divided EBITDA to determine the EBITDA multiple.
Relative valuation methods:
Relative valuation methods do not provide a direct estimate of a company’s fundamental value: They do not indicate whether a company is fairly priced; they indicate only whether it is fairly priced relative to some benchmark or peer group. Because valuing a company using an indirect valuation method requires identifying a group of comparable companies, this approach to valuation is also called the comparables approach.
Direct valuation methods provide a direct estimate of a company’s fundamental value. In the case of public companies, the analyst can then compare the company’s fundamental value obtained from that valuation analysis to the company’s market value. The company appears fairly valued if its market value is equal to its fundamental value, undervalued if its market value is lower than its fundamental value, and overvalued if its market value is higher than its fundamental value.
Replacement Value Method
Replacement value is different from Net Assets Value as it uses the replacement value of assets, which is usually higher than the book valuation. The term replacement cost refers to the amount that a company would have to pay, at the present time, to replace any one of its existing assets. Net replacement value of the assets indicates the value of an asset similar to the original whose life is equal to the residual life of the existing asset. Replacement value includes not only the cost of acquiring or replicating the assets, but also all the relevant costs associated with replacement.
Profit Earning Capitalization Value Method (PECV)
Capitalization of future maintainable earnings is carried out under this approach. Here it is important to work out future maintainable profit. For this purpose past profitability generally gives the indication. However, if past profit is not indicative then, future profitability may be estimated after taking into account present value of future expected profits.
Sales Multiple Method
A sales multiple is commonly used business valuation method and used as benchmark used in valuing a business. The Sales multiple is the ratio of the value of capital employed (enterprise value) to Sales. This method is generally used as a cross check for the values arrived under other methods. Sales multiples can vary depending on the industry. Therefore, it’s important to compare the multiple with other companies in the same industry or with the industry in general.
Profitability:
Make a business plan: Understanding the company’s profit numbers and creating a break-even analysis is the first step in making a business plan. For most small companies, the key portions of a business plan are the break-even analysis, a profit-and-loss forecast, and a cash flow projection.
18. Competitive edge for profitability: It is important to build a competitive edge for the business to achieve long-term success. The ways to achieve it is knowing the business competitors, making a product that is hard or impossible to imitate, being able to produce or distribute the product more efficiently, having a better location, or offering superior customer service and by protecting trade.
Understand the business profitability scenario: It is vital to to know the amount spent on purchasing inventory, paying the rent, compensating any employees, and covering any costs related to the business. Only by calculating this the company can be aware of the amount shell out at end of each month.
Hiring the best: It is important to hire the best skilled employees in the business to increase the profitability.
Sales: It is an an important factor in determining profitability. The return on sales ratio measures profits after taxes based upon the current year's sales. An effective sales strategy is essential in increasing a company's profitability.
Pricing:It is a key factor in determining profit. Careful analysis is necessary in determining the correct pricing strategy for a company.
Expenses:For a company to become profitable, income must exceed expenses. Expenses can be defined as the cost of resources used in the activities of a business. Profits for the company are determined by analysing what is left over after expenses are subtracted from total revenue. Any cost-saving measures initiated by a company will bring expenses down and increase overall profitability.
Staying in business: A consideration of a company's overall profitability is the cost of staying in business. Return on net worth shows how much profit a company generates on the money equity shareholders have invested. The return on net worth should at least be equal to the rate a business can borrow money from its creditors to achieve the cost of staying in business.
Measure business Profitability: An income statement shows a breakdown of income and expenses during the business year. One measure of a company's profitability is the profitability ratio.
Zaid Rayeen
Marketing and Brand Consultant
nextleaderbiz@outlook.com