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26 Apr 2015

Your Business is Worth More Than What You Think

Note: The author Andy Ng is a CA (Chartered Accountant) and a member with the Institute of Singapore Chartered Accountants (ISCA) since 1988
The other day I received a call from a friend who wants to know how much should his friend asked for when another business wants to buy over his business. 

This subject is called Business Valuation, and it is taught in MBA schools.  Today in just 7 minutes, you an be an expert on this subject. 

A business is worth what someone is willing (and able) to pay for it.  So the only true way to value your business is to put it on the open market and see what offers you receive.

Having said that, there are some common methods to value your business which give you a starting point for negotiations and a rough idea as to what your business is worth. What’s more, knowing how to value your business can help you understand where the value lies and maximise your business’ worth.

The most common method is based PE or Price Earning Approach. This method is based on the amount of profit that your company generates. To value a business you multiply its annual adjusted net profit by a number, i.e. the profit multiplier.

Value = Adjusted Net Profit X Profit Multiplier

So if your company makes $100K profit before tax in a year, then an indication of its value if we use a multiplier of 4 is $400K.

Looking at this from a buyer’s perspective, if they spend $400K on your business they will get a return on their investment of 25% per year (assuming the profit remains the same).  This is not bad when compared to bank interest rates.

Other points to note:
  1. The profit figure used to value a business is based on profit before tax.   This profit can be the most recent year or forecast profit for the coming year. 
  2. To make sure that your final profit figure is truly representative, we use adjusted net profit.  Adjusted net profit is profit based on standard arm’s-length principles.  Essentially, this means you can’t just pay yourself a small salary in order to bump up the value of your business!  Even owners of established businesses commonly take salaries below market rate (eg Apple's Steve Jobs took only US$1 annual salary). This could be for tax reasons, or to improve cash flow. Buyers will understand this, but will also expect it to be taken into account – which is why adjusted net profit is used.
  3. Using EBIT or Earnings (or Profit) Before Interest and Tax.  The reason interest is excluded is different businesses use different levels of owners' capital. For those that use very little owners' capital but higher borrowings (eg from banks), their interest expense would be higher. Thus we exclude interest to have a fairer comparison among different businesses. 
  4. Another variation of this is EBITDA or Earnings Before Interest, Tax, Depreciation and Amortisation.  It works on exactly the same principle as EBIT, but also excludes any financial adjustments to your profit for depreciation and amortisation (similar to depreciation, but for intangible assets rather than tangible assets).
What profit multiplier to use. Below are some things to consider when deciding what profit multiplier to use:
  1. The lower the perceived risk, the higher the profit multiplier (and vice versa).
  2. The higher the perceived growth rate, the higher is the profit multiplier. This explains why a 4-year old upstart mobile phone company Xiaomi is accorded higher valuation than veteran companies Lenovo and Sony.
  3. The more sustainable the profit is (or is perceived to be), the higher the profit multiple (and vice versa).
  4. Small businesses typically have lower profit multipliers than publicly listed companies because they are seen as a bigger risk, and their shares can’t be traded as readily. This is one reason that large companies buy smaller companies; the small business will be valued at a higher rate once it becomes part of a larger organisation.
Valuation Methods Other than Profits or Earnings

1.    Price Over Book Value Approach 
  • Based on the number of times over the book value of the business, i.e. net tangible assets. Number of times depends on industry and market condition. 
  • Suitable for businesses that depend on tangible assets, e.g. banks (assets are the loans), telcos, property companies and manufacturing firms. Not relevant for businesses that do not rely on tangible assets like those in high technology, information and intelligence. 
  • Obviously the assets need to be revalued by a professional valuer or outsider 
2.    Cost to Create and Add a Premium
  • Look at how much it costs you to create this business and add a premium, which is usually a time premium. 
3.    Acquisition of Customer Base Approach
  • All businesses are in the business of acquiring customers and serving them to earn a decent profit. As long as the lifetime value of the customer is higher than the acquisition cost, the customer is worth buying. 
  • Acquisition cost typically are the marketing cost (e.g. advertising, salesmen, and exhibitions). 
  • Lifetime value of a customer is the average net profits that you can get from a customer that you acquired over a certain time-frame (say 3 years). Rationale is that you only make money when your customers come back to you again. Also, when your customers come back, you can sell him other things and get him to refer other customers to you. Thus the lifetime value of the customer that you acquired is more than what the sales you can get from the customer. 
  • Suitable for businesses where there is a fixed acquisition cost per customer and there is high retention rate, e.g. credit cards. Base on $40 per new customer, a credit card company with 500,000 customer base is worth $20 million. 
  • In reality, need to adjust for customer attrition, a rate of 10% to 20% per annum is normal. 
4.    Other Rule of Thumb Approaches
  • Sales – more for professional service firms where the profit margins are high and stable. Common multiple is annual sales. 
  • Gross Profits – for businesses where the gross margin is fixed and stable.
At the end of the day, whatever the value of your business, it is only worth what someone is willing (and able) to pay for it.  For list of our courses, visit www.asiatrainers.com

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