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Small Business Valuations in Melbourne: All You Need to Know

Small Business Valuations Melbourne

A business valuation gets to the heart of why people are in business – to generate a realisable and valuable asset and not simply to provide an income stream (as in the well-worn phrase “to buy a job”).

A business valuation will help focus the owners on what they are seeking to achieve and, as such, helps to set the strategy of the business.

Business valuations are important to any small business owner because it is a measure of what has been achieved. The business value represents the wealth created by the business owner(s) after considering a normal level of income for the owner(s).

It is a capital asset, and you want it to be as big as practicable because one day you will need to dispose of it. It is worthwhile to seek out business valuation services from an independent valuer or business broker so that you can confidently communicate to potential buyers how much your business is worth.

A business’s value can oscillate just like shares listed on a stock exchange. However, unlike assets like shares, there is no index of value such as the stock exchange you can refer to.  Which means that the value of a business can only be determined at a specific point in time with a formal valuation.

By understanding how businesses are valued, you can work towards building your business’s value.

When are business valuations performed?

Valuations are often performed for legal reasons such as Family Law, in disputes (internal and external) and buying a business/selling your business.

But sometimes valuations are needed for business purposes e.g., for:

  1. Introducing new owners (e.g., shareholders, partners)
  2. Encouraging potential investors or lenders
  3. Bank purposes
  4. Tax purposes (usually on sale)
  5. Owner’s own purposes
  6. Determining a suitable asking price pre-sale
  7. Purchaser determining if offered price is reasonable
  8. Business succession

How are businesses valued?

There is a general misconception that business valuations relate to the Balance Sheet and to Net Assets (total assets minus total liabilities) shown on the Balance Sheet.

In most cases this is not the case. Going concern businesses are typically valued based on Future Maintainable Earnings that is earnings that are regarded as sustainable into the future for say 5 years.  So, although historical financial information is used in valuations, it is only used as a guide. This is because a valuation is about the future and not the past. Under this method, the purchase price of a business for sale does not depend on historical earnings – only future earnings – a certain level of operating net profit over multiple years.

Other valuation methods may be based on your existing business assets (including any intellectual property), customer base as well as the valuations of similar businesses will also impact your business valuation.

Capitalisation of Future Maintainable Earnings

Capitalisation of Future Maintainable Earnings is one of the most common methods to value a business if these earnings can be reasonably estimated. In this method, the product of two variables – future maintainable earnings and the multiplier – is used to arrive at the valuation of a business. The multiplier varies depending on the risks of the future operation and consequent results. The higher the multiplier, the lower the risk and the higher the value of the business.

The Rules of Thumb

A simple version of Future Maintainable Earnings is Rules of Thumb.  This may provide a close approximation of what a business is worth i.e., what it will sell for. It comes in two formats. The first is simply a percentage of annual sales, or the last 12 months of sales/revenues. For example, if the total sales for the preceding year was $100,000, and the multiple for the business is 50% of annual sales, then the price based on the rule of thumb would be $50,000. The second is method is a multiple of earnings before income tax (EBIT) and/or earnings before income tax, depreciation and income tax (EBITDA), valuing a business 3x or 4x its earnings.

Discounted Cashflows

Discounted cashflows is a purer form of valuation. The ability to use this method is connected to the ability to forecast income and expenses in detail over a lengthy period (say 5 years).  Many businesses cannot do this. To remove the effect of inflation (use of money over time), the future cashflows need to be “discounted back” from their future value to present day value. Capitalisation of Future Maintainable Earnings is an approximation of the Discounted Cashflow method.

Net Asset

Where no Future Maintainable Earnings can be ascertained the valuation will revert to a Net Asset valuation. This can either be on a “going concern” basis or a “liquidation” basis (sometimes called a “fire sale” basis). A going concern basis means the business can continue but no future maintainable earnings can be detected.  A liquidation basis would mean the business cannot continue.

Think Business Value Every Day

For most business owners, the worth of their business is net operating profit multiplied by a risk factor called “the multiplier”.

In practice, this means every time a new customer comes through the door, or a new contract is available for tender, it can be interpreted based on its contribution to the value of the business. The longer you keep the customer, the higher the value of your business.

Some keys points to consider:

  1. Always be aware of the continuing value of your business
  2. If you met any of the 8 points under “when are valuations performed” above, ensure you seek a formalised valuation
  3. Ensure you understand how a valuation is derived
  4. Relate your business to the creation of a valuable asset (an asset with value separate from your expected income stream)
  5. Seek advice in relation to valuations

This is a summary intended for guidance.  If you want to find out more about business valuations, please contact a suitable professional and discuss your specific circumstances before acting on anything contained in this document.

Ahead for Business has an expert team of Chartered Accountants specialising in conducting Business Valuations in Melbourne. We can provide you with a detailed valuation report for your business. Call us on 03 9867 7711 to find out more.

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