The structure of the economy stands upon the pillar of business. Not only the giant corporations but also the small start-ups add valuable cost to the circulation of income. No matter what shape or size business has, it participates in the economy very much with its functioning existence. There are various metrics to measure the success of a business. But valuation is the one which is currently more preferable to keep an eye on the growth of the business.
Public companies show their valuation by referring to the price of their share and associated market capitalisation. It is important in merging and acquisition activity, and also in fundraising. But most importantly, to see where the business stands currently and in future, what will be its position.
Now the question is, How to value a small business?
Certain principles define business valuation.
Business Valuation Principles
Principles of valuation are based upon the analysis of different factors. It also includes data points to determine a company’s value. There are financial metrics, such as revenue, gross profit and even EBITDA (Earnings before interest, taxes, depreciation, and amortisation). These matrics help to feature in the valuation analysis.
Other factors such as consumer base growth for the market, barriers in industry entrance, and the threat of regulation impacting growth also feature.
Tangible assets such as intellectual property if present, it will also be added into business value. If there are vital relationships or strong brands, it will be added in the goodwill.
Price to Earnings (P/E) Ratio Method
Public traded companies use this price to earning ratio method commonly. It is calculated by dividing the market value price per share by the share which the company receives. In short, earning per share will be the portion of the net income of the company. Which will be earned if the profits are distributed to the shareholders.
Different companies set different ratios accordingly. For example, if the share price is said to be $20, and EPS is $2, then the price to earnings ratio will be $10. A higher P/E ratio means that if an investor wants to spend more on the assets, he would be expecting higher profit in the future too.
EBITDA Multiple Method
It is also one of the popular methods of business valuation. This method relies on the multiple of EBITDA to arrive at the enterprise value of equity and debts of the company. It is important because it works as a performance indicator of the company. EBITDA multiple method is based on the actual results on the company and industry standard multiple can also be applied to it; this is the best advantage of this method that is why it is also preferable.
Even though it is a popular method, it has a drawback to the company valuation. That is, it is not valid with pre-profitable companies, for instance, technology enterprises. The reason that these companies do not enjoy EBITDA is because of the amount of capital they invest is significant for product development. Also, they acquire customers more quickly as compare to the competitors. Also, the insights into comparative company multiples are not available in this approach. That makes it hard to analyse the arrive at realistic multiple.
Discount Cash Flow is one of the ideal methods for valuing newly settled businesses. It works by taking the expected cash flow of the future. Then applying a discount rate to arrive at the current cash value to get the company valuation. To pre-revenue companies, it gives a little benefit by modelling the prediction of future cash flows. Which is following by a back work to arrive at the present valuation.
Analysts take this method as a weak methodology because of the uncertainty of future cash flows. Like any prediction, the longer you plan, the more unlikely the prediction will be. Plus microeconomic and macroeconomic factors can also affect it. Even though all these negative remarks, this method is still the popular one for big technology enterprises.
..Thre are a number of factors that you need to consider before agreeing on a valuation for purchase or selling of a business. In other words, mergers and acquisitions. It will cause both the seller and buyer to believe that they are making a fair deal. Ther are usually known as synergies.
When you purchase a company in a similar field as your current business, you can rationalise the cost between the two businesses for having one office instead of two. It will not only minimise the expenses and increase the profit margin. But also, it will contribute to a higher valuation to your business.
At the other hand, the seller may not be able to measure such cost savings. So he will be willing to sell you on the basis of the valuation he estimated.