“Price is what you pay. Value is what you get.”
Let’s be honest about this; valuing a business is subject to huge amounts of bias, context, external and internal variables, many of which will be completely missed by traditional valuation methods. In truth, the valuation process can only really be done on a case-by-case basis that captures the nuanced risk profile of each business. How else can you capture the future growth prospects, the staffing structure, the stability of the customer base, the strength of competitors etc etc etc, the list goes on.
Compound that with the fact that there are several different valuation methods; discounted cash flow method, capitalisation of future maintainable earnings or net asset value to name a few. Not even the definition of profit is universal; EBIT, EBITDA, should you average the profits? Over two years? Three years? More? There is significant confusion amongst trained professionals as to which approach is best, let alone business owners and investors.
So, we are going to keep this simple. In this blog, we’ll outline how valuations play out in the real world. That is to say, what valuation method is broadly used across the West Australian marketplace and what are the key elements to the valuation equation?
First, a few definitions:
- ROI: Return on Investment
- Adjusted Net: A normalised profit generated over a 12-month period
An accurate valuation boils down to three key elements; (1) maintainable net profit vs. (2) risk, mapped against the (3) marketplace of other businesses for sale.
1. Net Profit
This is arguably the easiest element to quantify. The net profit isn’t what you send to the ATO, for a valuation we use something called an “Adjusted Net.” Think of it as a net profit the new owner of the business is likely to receive from the business assuming they have zero debt (or interest). That means you can add to the profit any one-off expenses you have incurred in the past, as well as any expenses that don’t relate to the business moving forward.
2. Risk (Represented as an ROI %)
This element is more difficult to quantify than the net profit, but a disciplined approach underpinned by a clear logical framework can be effective in quantifying risk. The variables you assess can differ depending on the industry or business you are reviewing. To learn more about how to assess these variables enquire about our workshops here.
Hint: One way to think of the ROI % is as follows:
How much of the total purchase price will a buyer be expected to receive in return in the first year following settlement? Ie, 40% ROI means the buyer will get 40% of the total investment back in profit in the 12 months following settlement.
Check out pages 6 – 9 of our Due Diligence Playbook for some of the areas to check when quantifying risk.
3. Marketplace
This is an assessment of the competitive landscape a business is being sold in – don’t forget, a business gets commoditised like anything else once it enters the market for sale and will need to compete with other businesses on the market.
For example; if there are 100 businesses on the market selling for a 33% ROI, and your business enters the market for sale at a 31% ROI, your business will need to represent less risk for investors vs. the other 100 out there in order to attract interest.
“Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.”
Alignment
Despite all the above, some buyers will still pay more, or less for certain businesses because every buyer may perceive risk differently. This is something we call alignment. A buyer’s experience, expertise or otherwise may alter the perceived risk of a business, and will therefore arrive at a different ROI to the general market. Finding these buyers can improve the sale process substantially.
Of course, an open market sale of this kind is not the only exit option available to most business owners. There are strategic acquisitions by competitors or customers, trade sales, IPO’s or management buy-outs to name a few. Some businesses will naturally lend themselves to one exit option over another. For a full assessment of your businesses exit options enquire about Octavian’s Exit Options Analysis workshop.