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INTRODUCTION:
As a business valuer, it is very common to see business valuations performed by those inexperienced either incorrectly interpreted by their clients or incorrectly prepared. Depending on the transaction, generally either the business or shares (equity) will be bought. Sometimes only part of a business maybe bought such as goodwill and plant and sometimes assets and liabilities may be taken over. This means that when assessing value, you need to understand exactly what you are purchasing and how that item is valued.
Today therefore I want to talk about valuing a business as opposed to valuing the equity.
Figure 1: How to buy a business - are you buying the cat or the rug or both? Photo courtesy of Lara Scolari Gallery Balmain
1. Be Very Clear As To What You Are Purchasing
If you are buying the business, establish what components that are included with the purchase. Are you buying plant and goodwill only or does it include stock or something else?
When your business valuer values the prospective business, typically they will use what is known as the Capitalisation Of Future Maintainable Earnings Method. The capitalisation rate will be typically between 1 - 5 times. However, once this rate is applied to normalised earnings (EBIT), this calculation is meant to represent what the business is worth and includes assets that will be needed to run the business. Typically it will include plant and goodwill.
Having performed this calculation and assessed the entity for any surplus assets, the business valuers Sydney will restate the balance sheet and calculate the value of goodwill.
2. If Buying The Business
If buying the business, make sure that you look at the adjusted balance sheet components to determine the calculated value. If you are buying the goodwill only, naturally you will only pay for the goodwill. If you decide to pay more than the calculated value, make sure you can justify why you have decided to do so (e.g. opportunity to improve the profits where the existing owner is either not doing or has not seen the potential).
Figure 2: Buying a business asset can often have hidden costs despite being dressed up. A pet for example may have been bought but then you realise they need injections and urgent medical attention!
3. If Buying The Shares
If you are buying the shares in a business, debt needs to come off the maintainable earnings calculation. This may seem like common sense, but it is very common for people to be confused and pay for a entity small business valuation Sydney when in reality they should have received an equity valuation which takes into account amongst other things, debt.
By paying a value excluding debt, the end result is of course paying too much as you have now also taken over a share of the debt which the shares own!
CONCLUSION:
Business valuations can be a confusing science. Be sure to understand how a business is valued and make sure that you pay for only what you are getting.
Failure to get proper advice can become extremely regretful!
