Not all businesses are valued in the same way. In fact, there are over twenty different valuation methodologies. And, applying different methods will not produce the same result. To know what your business is really worth, you need to identify the most appropriate valuation methodology to apply to your business.

Despite the large number of valuation methodologies that exist, there are five that are used in over 95% of SME valuations. These are: capitalisation of future maintainable earnings; discounted cash flow; net realisable assets; industry method; and, cost to create.

Capitalisation of future maintainable earnings focuses on the earnings or adjusted profits of the business. It values a business at some multiple of its maintainable earnings, with the multiple being determined by the risk rating of the business. Most SMEs have a multiple somewhere between one and five times. This approach is commonly used for mature businesses where there is a history of reasonably stable earnings.

The discounted cash flow method looks at the free cash flow of the business and calculates value based on the sum of the forward cash flow adjusted to its net present value. This method is commonly used for businesses where there is a defined time life to the business and where cash flow is reasonably predictable.

As the name implies net realisable assets simply focuses on the tangible asset value of the business. The approach ignores the existence of any goodwill and assumes that value exists principally in the realisation of the assets held by the business. This approach is commonly used for farming businesses or businesses where there is significant investment in plant & equipment or other assets. Some heavy engineering or road transport businesses may use this approach.

The industry method is the least scientific of all the approaches and is sometimes criticised for its lack of rigour. It assesses value by a simple formula that will be calculated against some factor of the business such as revenue, gross profits or recurring income. It is only used for small businesses and it seeks to reflect market activity. For an industry method to exist you need to have a reasonably large number of businesses in the sector, have ongoing turnover of these businesses and where some level of market information is available. The businesses all typically have a very similar business model. Examples of business sectors where an industry method does exist include newsagents, pharmacies, cafes, real estate agents and financial planning practices.

The cost to create method is a more recently accepted method that has emerged due to the large number of micro businesses. It values a business on its tangible assets plus a limited premium for goodwill based on the fact that a buyer would prefer to pay such a premium for having the business established rather than incurring the cost, risk and time of trying to establish a small business. This goodwill premium is normally limited to up to one years net income.

Understanding the true value of your business requires first of all to determine what valuation method is most appropriate. This can only be done by understanding the business and its underlying characteristics. For most businesses, by a process of elimination you can determine the one or two most appropriate methods.

Failing to select the right valuation methodology can result in an assessment of value that is highly inaccurate. Valuation methodology is not simply determined by the industry or sector you are in. It is also influenced by the size, age, profitability and other characteristics of the business.

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