The market for small to medium enterprises (SMEs) is very inefficient, with the majority of businesses (estimated to be 90%) sold without the intervention of a specialist business broker. This, and a general lack of business valuation advice sought by vendors and purchasers of small businesses, produces significant variations in the returns or yields reflected in the transactions that do occur. In the SME market, yields are often converted to a year’s purchase which is also referred to as an earnings multiple.
Whilst there are niche industries where businesses are readily sold to specialist operators, the majority of the market does not have any reference point to adequately price the risk for owning and operating small businesses. A specialised business valuation provides a reference point and seeks to quantify similar returns or multiples achieved for businesses actively marketed for sale or sold.
There are many different methods for valuing a business, however, the overall concept is common for each approach. The methodologies work on the basis of substitution. Further guidance of this principle is detailed in the International Valuation Standards (IVS) 2007 as follows:-
Valuations of any type, whether undertaken to estimate market value or a defined non-market value, require that the Valuer apply one or more valuation approaches. The term “valuation approach” refers to generally accepted analytical methodologies that are in common use. In various States these approaches may be referred to as “valuation methods”.
Market based valuations normally employ one or more of the valuation approaches by applying the principle of substitution, using market-derived data. This principle holds that a prudent person would not pay more for a good or service than the cost of acquiring an equally satisfactory substitute good or service, in the absence of the complicating factors of time, greater risk, or inconvenience. The lowest cost of the best alternative, whether a substitute or the original, tends to establish Market Value.
The identification of “substitutes” in the SME market is difficult given the variation that occurs from business to business. However, some commonality can be observed when analysing business transactions in a consistent manner.
In some instances SMEs are valued utilising a Capitalisation of Earnings Approach (via a market derived yield or multiple) or Direct Comparison on industry specific criteria, for instance, the rate per dollar of turnover utilised in the valuation of specific service firms. Whilst there may be some conjecture over the suitability of one approach over another, the market or potential buyer profile for the type of business in question generally determines the approach to assessing the market value.
There are some valuation methodologies that attempt to price risk through the application of detailed and complicated financial models, however, evidence that purchasers use these sorts of methods to quantify value is limited in the smaller business market.
The valuation of a business should be approached on a case by case basis. To discuss further or seek additional information about Robertson & Robertson please navigate to the appropriate page or contact Lachlan Robertson.
Robertson & Robertson has 38 years experience in providing specialised valuation advice. If you are a business owner looking to sell or purchase or are seeking valuation advice for taxation or legal purposes, please CONTACT US.
