Most SME owners typically are not overtly concerned about the valuation of their business on a day-to-day basis. Usual figures and metrics business owners track on a more daily basis are likely top line sales growth, inventory levels, net profitability, liquid cash flow etc.
The few scenarios when business valuation is no longer an afterthought are usually:
- Exiting the business via a sale of company
- External investors taking equity position in the company
- Buying out shareholders
- Preparing a business loan application to banks
- Offering key employees equity remuneration scheme
As SMEs are typically unlisted companies with no floating share price, business valuation of SMEs could be tricky and subjective, depending on which inputs are used.
There are some commonly accepted methods to derive valuation of a business. We will share three of them in detail below.
Do note certain industries might find it more appropriate to use one valuation method versus the others. We will discuss this as well in each of the valuation methods shared below.
Asset Based Approach
This valuation method works on going concern approach. Net asset value of the business, such as properties less depreciation, is deducted from liabilities, such as SME loan or outstanding lease, with the difference being the derived business value.
The calculation seems to be quite simple, but the devil lies in the details, wherein it is complex to decide what assets or liabilities should be included for reaching the valuation. Also, it is difficult to determine a standard of measuring their value, and also the actual assets and liabilities value to reach the valuation.
Another challenge is that balance sheet of various businesses may or may not include intangible assets such as proprietary IP rights and brand goodwill, which are important in deciding the valuation of the business.
On paper, the derived valuation might be under-valued due to exclusion of intangible assets that does add real value to the business.
Asset Based valuation can be done in three ways – Economic Book Value Calculation, Liquidation Value Calculation, and Valuation at Replacement Cost.
Under Economic Book Value, the accounting book values of assets are adjusted to their current market value, while in Liquidation Value method an estimated value of assets at liquidation less the cost of liquidation is used. In the Valuation at Replacement Cost method, the cost to obtain the same assets from scratch is used for valuing assets.
Using the asset based approach for valuation is suitable for businesses that are not very operational but derives income or value mainly from capital assets. These include real estate holding companies or heavy machinery equipment rental business.
Comparable Transaction Valuation
This method is usually used when the valuation is carried out for purpose of putting the company up for sale. Under this method, a peer group is compared on same standards. For valuation purpose, the peer group used would be similar companies in the same industry, as well as market capitalization.
Thereafter, the companies are assessed on common multiples such as EV/EBITDA, PE ratio, PEG ratio and so on. For fair valuation, the company should be assessed on more than one standard to identify the current and the potential value of the company.
Things look easy when there are set standards on which the companies have to be compared. However, this approach has its own set of drawbacks wherein collecting all the past data of the company is difficult, especially the transactions conducted between private companies.
Therefore, this approach is not used solely, but in combination with other approaches. Comparable Transaction Valuation is often used along with Discounted Cash Flow method to present fair value of business.
Discounted Cash Flow Method
It is the most popular method to arrive at nearly accurate valuation. The term discounting is used because the value of the future of the cash flows is reduced to present.
Discounted Cash Flow method takes inflation into account while calculating the valuation of the business. The business's projected future is cashflow is discounted by the time value of money, to determine the current value. Time value of money includes inflation.
For instance, which offer do you think is better: An offer of $1,000 right now, or $100 per year for 12 years. At first glance, it might appear that $100 for 12 years is a better option because it nets a total of $1200 at the end of 12 years. However, inflation rate is not taken into account.
Assuming an inflation rate of 5%, the $100 amount, which you might have got next year, is worth $95 today. After 12 years the value of $100 would be less than around $56. Discount rate is used to arrive at a present value.
Though all the methods are commonly used for valuing a small business, the Discounted Cash Flow gives the best picture of the business.
This method gives a better picture of company’s value at present, and is more relatable for the investors, as well as, the business owners. This method is suitable for businesses that has high growth potential, but might not be profitable yet.
Most companies usually employ a combination of two or more methods for calculating the valuation of the business. Depending on specific sector, 'multipliers' are usually applied on valuations.
For example, businesses in the tech or software industry will have a higher multiplier attached to their valuation, versus a traditional multi-chain F&B business, due to scalability.
For high growth potential startups, valuations are also typically subjective and dependent on investors personal evaluation on the business model. Thus, it is typically tougher for such startups to qualify for startup business loan or to be valued at traditional mainstream metrics such as the ones shared above.
SME owners will also look to 'window dress' their financials before a business valuation exercise. Some legitimate methods to improve valuations includes paying down liabilities such as the popular SME Working Capital Loan, which has no early redemption penalty. And improving cash flow by tightening credit collections on accounts receivables while pushing for longer credit terms on trade payables.
Even if you're not looking to exit your business anytime soon, it is still encouraged to conduct a business valuation annually to benchmark your business's paper value and spot opportunities for growth.