What Does Valuation Mean?

Valuation is a methodical assessment and determination of the true worth of a business. Ultimately, in a business sale, valuation is the price the potential buyer is willing to pay and the seller is willing to accept; or the price the seller is asking and the potential buyer is willing to pay.

Valuing an enterprise is an immersive process involving all manner of transaction steps, activities, and endeavours such as due diligence, valuation, assessments, negotiations, bargaining and trade-offs between the seller and the potential buyer.

A company’s profitability, revenue, cash flow, earnings growth, growth prospects, brand recognition, intellectual property, all assets and liabilities as well as prevailing market conditions, demand and supply can vastly affect its valuation. But a valuation arrived at is largely dependent on the method used; what is being valued is as important as how it is being valued.

A good valuation is best achieved with a combination of any number of methods. Various methods used in business valuation include:

• The multiplier method. In this valuation method, adjusted net profit, EBIT or EBITDA is multiplied by a multiple (a number, could be 2, 3, 4, 5, 6, 7, or even 8) – it is usually an industry multiple.

The valuation is calculated as a multiple of the adjusted net profit, EBIT or EBITDA. A specific multiple used in a valuation broadly depends on the type and size of the business, its industry and growth prospects.

As the term implies, adjusted net profit is net profit adjusted to account for certain costs and expenses not considered when calculating the net profit. For example, if the current owner-manager had not been receiving appropriate salary from the business.

When using adjusted net profit, the valuation is calculated as follows: Adjusted Net Profit x Multiple (of industry) = Valuation. The multiples of earnings approach is usually the preferred method of valuation of a lot of SMEs.

An enterprise’s EBIT or EBITDA is also used in this method of valuation. A multiple can also be applied to cash flow or even gross margin.

• Asset valuation. In standard practice, a company’s account will show the net book value (net asset value) of the business. It is assets less liabilities. To get a valuation, the net book value is re-assessed to determine the current net worth of the assets rather than what has been stated in the books.
• Discounted cash flow forecast. In this valuation method, estimated future cash flow is used to determine the value of the business. It is done by assessing how much cash the business generates yearly. The cash flow figure derived is then forecast (say, 5 years) and calculated as the value of the business.
• Cost of starting a similar business. This valuation method estimates the capital outlay of starting a similar business currently to show how much the established business is worth based on current entry costs.
• Rule of thumb. Depending on the industry, a business could also be valued based on the number of variables. In the retail industry for example, such variables could be the number of outlets, turnover and customers.