Many business owners wait to find out what their business is worth until they’re selling, restructuring, working on a succession plan or are involved in a property settlement. But a valuation can also be the first step to growing a business.

“If you have plans to sell or take part in a merger, it’s best to start planning at least three years ahead,” says Greg Hayes, Chairman of Hayes Knight National Group and author of A practical guide to business valuations for SMEs. “Potential buyers or partners are looking for trends – they want to see figures for a number of years. A valuation is a good starting point because, once you have a base figure, you can work on a meaningful strategy for increasing and documenting that value.”

A valuation can help you identify what’s creating or holding back value in your business – how you can develop its strengths and reduce its exposure to risk. “After a valuation, most businesses can identify four or five options for building value by increasing revenue, improving margins or reducing costs,” says Hayes.

While there are over 20 different valuation methodologies available, just five are used in more than 95 percent of SME valuations.

1. Capitalisation of future maintainable earnings – the earnings or adjusted profits of the business.
2. Discounted cash flow – the free cash flow of the business.
3. Net realisable assets – the tangible asset value of the business.
4. Industry method – a simple formula calculated against some factor of the business such as revenue.
5. Cost to create – the tangible assets of a business plus a limited premium for goodwill.

“It’s part of a professional valuer’s job to identify the most appropriate,” Hayes continues. “For example, a farm would lend itself to an asset-based valuation as most of the value would lie in the land, buildings and machinery. On the other hand, a medical practice or advertising agency might have very few tangible assets so they’re more likely to be assessed on their ability to generate an income.”

The industry method can be used to simplify the calculation for businesses such as pharmacies, accounting practices or coffee shops – those in industries with a large number of participants, a consistent business model, a reasonable level of buying and selling activity and some level of publicly-available information around that.

“Valuers can use this information to create different parameters,” says Hayes. “For example, small accounting firms are currently valued at between 75 cents and one dollar for every dollar of annualised revenue. They can then take this range as a starting point.”

Whether or not the industry method has been applied, the final valuation will always take the risk profile of the business into account – the lower the risk the more the business is worth.  Hayes has identified five major areas that a professional valuer will investigate.

1. The revenue stream. Is it growing, plateauing or in decline?
2. Profitability. How profitable is the business once the income has been adjusted for any abnormal items? For example, if the owners have been paying themselves much more or much less than the market rate, this needs to be taken into account.
3. External factors that might affect the future of the business. This could be at industry level, such as pending changes in legislation that might have an impact on the earnings stream of a financial services business. It could also be at a business level – for example, if a business is dependent on a single customer for 80 percent of its income, losing that customer could change the nature of the business overnight.
4. The product or service. Is this a ‘me too’ business or does it have something unique that gives the owners a competitive advantage?
5. The nature of the goodwill in the business. This could be tied to a particularly good location such as a busy street or proximity to a railway station. If this is the case, could the owner lose that advantage? Are there plans to change traffic flow or, if the building is leased, how secure is the tenure? If the goodwill is personal, have all of the successful systems been formalised and clearly documented so that they can be reproduced?

“Professional valuers take all of the appropriate factors into account in assessing what your business is worth,” says Hayes. “Importantly, they also provide information that can help you to plan for the future.”

Read more about business valuation and How to increase the value of your business