Small and Medium Enterprises (SMEs) are valued differently at different stages of the business life cycle. Whether you’re contemplating a sale, seeking investment or planning for the future, succession is an inevitable reality in every business owner’s journey, and it is never too early to start growing the value of your business.
This article, the first in a 5-article series, lays the groundwork for understanding the various facets of valuing small and medium-sized enterprises in Australia. The series will then continue to discuss the different ways SME businesses are valued and the key drivers and levers business owners can use to enhance the value of their businesses.
The essence of SME valuation
Valuation is more than just a financial exercise; it’s a reflection of your business’s position in the market, its past performance and future potential. For SMEs, this process can be challenging due to the unique nature of each business and the lack of readily available market data.
So, how are SMEs valued?
Core valuation methods
Understanding the different approaches to valuation is crucial. Each method offers its perspective and can be suited to different types of businesses and situations.
Earnings multiple method
This type of valuation is most commonly used in the SME market for a majority of businesses in varying industries as it deals with the facts of historical performance and market conditions. It involves multiplying the business’s normalised earnings before interest, taxes, depreciation, and amortisation (NEBITDA) by earnings multiple. Accurately determining this multiple, which reflects the perceived risk and growth potential of the specific business, the market, as well as other factors like the cost of capital, is the key.
This approach, which considers the company’s total net assets, is particularly relevant for businesses with significant physical assets like some types of manufacturing companies or businesses that own large fleets of vehicles or other assets.
Discounted cash flow (DCF)
DCF provides a more dynamic valuation by forecasting future cash flows and discounting them to their present value. This method requires a thorough understanding of the business’s prospects and the ability to make accurate financial projections. It is, therefore, used frequently where there is a higher degree of certainty in those future revenues and costs, for example mining tenements.
Market comparison or ‘Rule of Thumb’
Using this method, the value of a business is determined by comparing it to similar businesses that have recently been sold. This approach is often used in conjunction with other methods to provide a market-relevant perspective. This approach is used less often in the SME space as it is often hard to find information on other transactions. Examples of businesses that sometimes use this methodology are subscription-based services (e.g. internet providers) who often use a multiple of revenue.
Influencing factors in valuation
When determining the value of a SME, there are several factors that can have a significant impact. These include, but are not limited to:
- Industry trends: The current and projected state of the industry plays a crucial role as industries on an upward trajectory tend to have businesses with higher valuations.
- Financial health: Profitability, revenue trends, cash flow stability, and financial management practices are all metrics used to measure financial health. Healthy metrics usually translate to higher valuations.
- Customer base: A diverse and loyal customer base can significantly enhance a business’s value while dependency on a limited number of clients can be a risk factor.
- Intellectual property and technology: The ownership of patents, trademarks, and cutting-edge technology can add value to a business.
- Market position and brand: A strong market position and a well-recognised brand are often associated with higher valuations.
- Human resources: The quality of management and staff, along with company culture and employee relations, can impact valuation. Particularly in privately held businesses, the reliance of the business on the owner or their family is one of the key drivers.
There are 3 sure things in life, at least for business owners: death, taxes and succession. Knowing what your business is worth today and what you want it to be worth when succession does occur is critical to achieving financial success. In the upcoming articles in this series, we will delve into specific aspects of the ‘Earnings Multiple Method’, and how you can positively influence your business’s valuation.
For more information on how SME businesses are valued, contact your local William Buck business advisor.