There are a myriad of tools when determining the value of businesses. Many people undertake this exercise before they sell their business, but it’s important to periodically value it in order to manage it properly.
Once you learn how, the process becomes easier and becomes quicker and more effective over time, allowing you to assess other business opportunities that may also compliment your existing venture. See below for an introduction to two commonly used methods used to determine an organisation’s value.
Cash Flow Models
These type of analyses, such as a discounted cash flow model, will give an indication of a business’ present value based on estimated future cash flow, thus allowing you to asses it’s suitability for investment. If the buy in works out lower than the current value estimate, it can indicate sound investment potential.
For this analysis you’ll need to know the free cash flow position, which is the operating cash flow, (money generated via the normal activities of the business), minus the fixed expenses (which expenses you use in your analysis will depends the type of cash flow model you select).
In other words, say you come across what appears to be the best coffee shops for sale, you may choose to use this method as a means to assess how attractive this investment prospect actually is on paper. You’ll need to begin by taking the operating cash flow, in this case sales of food, coffee and other beverages and deduct the non negotiables costs such as rent, staff, produce, insurances and bookkeeping. You’ll then need to take this free flow cash projection and apply a discount factor it to arrive at a present value, and added together these make up your overall valuation. How you calculate your discount factor can vary, with a higher factor generally lowering a valuation. A discount factor, typically concerns how likely the business is to meet its projections and is thus calculated as the weighted-average cost of capital (often an average between borrowing money and equity investment).
This second approach is also important to sellers and buyers alike as it will consider the business’s value based upon if it were sold at a specific period. Market valuation is also useful if you wish to factor in non-financial characteristics into your overall evaluation. A comparable company analysis is an example of a simple market valuation which compares a business to similar publicly listed enterprises in order to gain a base valuation estimate.
It is important to know that market value will fluctuate over time and is also influenced by when in a business cycle it is conducted. For this reason, when using a market valuation on a business, also take into account the broader economic climate when considering what investment action to take.
If you’re not experienced with the organising principles of business valuation, outsource the task to someone who is to ensure you have an accurate assessment of a business whether buying, selling or planning for its future.