Factors That Drive Business Valuation & 7 Ways To Improve Yours
Do you know how much your business is worth? Or better yet, how to increase that value?
Understanding business valuation isn’t just about having a number you can proudly hang your hat on. It’s crucial for getting clear on the health and performance of your business and achieving your financial goals.
In this video and article, we’ll delve into the internal and external factors that impact business valuation (also known as enterprise valuation), with key takeaways and action items that you can implement to start seeing results.
Why Business Valuation Matters
Firstly, understanding what drives business valuation is paramount for several reasons.
- Informed decision-making: Understanding the value of your business allows you to make informed decisions and strategise effectively.
- Business growth: A clear grasp of your business’s value allows you to identify areas for improvement. By understanding the factors influencing valuation, you can work on enhancing them to drive growth.
- Attracting investors: Investors are more likely to invest in your business if they have a transparent view of its value. A higher valuation increases the attractiveness of your business to potential investors.
- Exit strategy: If you plan to sell your business or pass it on to a family member, knowing its value is essential. It allows for fair negotiations in determining the buyout amount, ultimately ensuring you receive the best possible return on your investment.
- Financing opportunities: When seeking loans or financing, lenders assess your business’s value. A higher valuation can improve your chances of securing funding on favorable terms.
- Benchmarking: Your business’s value serves as a benchmark for tracking progress. It helps you compare your performance with industry standards and competitors.
- Risk management: By identifying areas where your business can improve its value, you can mitigate risks associated with underperformance.
- Assessing financial health: Your business’s worth reflects its financial health. Monitoring this value over time provides insights into your financial stability and performance.
Key takeaway: Knowing your business’s value isn’t just about a number. It’s like a secret weapon for making better business decisions, being clear on your business’s financial position, facilitating growth, and helping spot opportunities so you can reach your financial goals faster.
How to Calculate Business Valuation
The equation for valuing a business is quite simple. It’s your maintainable profits and earnings times a certain multiple.
If you have maintainable earnings of $1M, and you come up with a multiple of five, the value of your business is $5M.
The first part of the equation – profitability – heavily determines the outcome you get. A business with $10M in profit is going to be much better-placed than one with $1M in profit.
But what can you do to improve the multiple? Because if you have maintainable earnings of $1M, it’s clear a multiple of 10 instead of five is a much stronger position to be in.
The 7 Factors That Drive Business Valuation
1. Performance Quality
Internally, the first factor that drives your business valuation is the quality of your performance. Quantity of performance is reflected in dollars, but quality is about percentages. Specifically, your gross profit percentage and net profit percentage.
A business with a high gross profit percentage is more attractive because it offers greater value per dollar of growth achieved. For example, for a business with a 20% gross profit, every million dollars of growth adds $200,000 in value. In contrast, a 40% gross profit business adds $400,000 for the same growth.
Moreover, your net profit margins matter. A business with a 20% net profitability is more valuable than one at 15%. So a higher net profit margin not only makes your business more profitable, it also makes it more valuable.
Key takeaway: Robust profit margins are instrumental in improving business valuation.
How to implement: Regularly review and analyse your financial statements to identify areas where you can increase profit margins. This includes reducing unnecessary expenses and optimising your pricing strategies, especially pricing for risk.
2. Level of Growth
The second internal factor to consider is the level of growth in your business. Buyers are willing to pay a premium for businesses that have shown consistent growth and demonstrate potential for future expansion. If your business has consistently grown from $1M to $2M to $5M, it’s more appealing to potential buyers. On the other hand, stagnant revenue and growth can negatively affect your business’s valuation.
Additionally, assess how much untapped potential your business holds. The more areas for future growth and expansion you can identify, the more valuable your business becomes.
Key takeaway: A business that exhibits continuous growth and potential for expansion commands a higher valuation.
How to implement: Develop a detailed plan for growth that outlines specific steps and milestones for expanding your business, including new markets, product lines or customer segments.
3. Cash Conversion
The third factor within your control is cash conversion. The most attractive businesses to deal with are those with high margins and low asset requirements. This is because these businesses generate significant profits without having to invest heavily in assets. On the contrary, businesses with low margins and high capital requirements are less appealing.
If your business can generate substantial cash, it’s more valuable. Achieving this relies on the margins we’ve discussed and the efficiency of your asset use.
Key takeaway: High-margin, low-asset businesses are more attractive to buyers, as they generate substantial profits without heavy asset investment.
How to implement: Focus on improving profit efficiency by increasing margins and minimising the assets required to generate returns.
4. Owner’s Dependency
Another internal factor is owner’s dependency. How easy would it be for your business to run if you were to vanish for a month or two? Would it be business as usual, or would it gradually descend into chaos?
The less a business relies on an owner’s daily involvement, the better off it is. A systemised and process-driven business will be one that runs smoothly even if the owner is absent for an extended period.
Key takeaway: A business that can run efficiently without heavy dependence on the owner is more valuable.
How to implement: Develop an operations manual that clearly outlines all critical business processes, allowing your team to operate smoothly even in your absence.
5. Your Industry
Moving to external factors now, the fifth element to consider is the industry your business operates in. The perception of your industry within the wider marketplace carries substantial weight. Ask yourself: How is your industry perceived? Is it currently thriving, or is it considered less attractive? An industry considered “hot” or thriving is significantly more appealing.
Key takeaway: The market’s perception of your industry plays a pivotal role in determining your business’s valuation.
How to implement: Encourage satisfied customers to leave positive reviews and testimonials. This social proof can enhance your reputation and for your industry overall.
6. The Economy
Another external factor is the economy. The state of the economy at the time of sale can significantly affect your business’s valuation. A strong economy usually results in a better multiple, even if your business is exceptionally strong.
To highlight this, in 2022 we worked with a business that was thinking of selling because of how the economy was booming at the time, but they wanted to wait until their profitability increased. After doing the calculations, we discussed how they’d get more value by selling at the time due to the economic benefits of a greater multiple, rather than waiting to increase their profitability but risking the economy worsening.
Key takeaway: The state of the economy at the time of sale can impact your business’s valuation. A strong economy usually results in a better multiple.
How to implement: Consult with financial experts to analyse economic indicators and develop a strategic timeline for selling your business during optimal economic conditions.
7. A Bit of Luck
The final external factor is a bit of luck. Sometimes, the art of timing and positioning can shape your business’s valuation.
You might have heard the stories where a developer wanted to build a set of apartments and needed to buy the six existing houses on the block to do so. The first four owners sold not knowing the circumstances, but by the time it got to the fifth and sixth houses they knew what was going on. These owners had a significantly stronger bargaining chip when selling to the developer. Just like the real estate market, businesses can be in the right place at the right time that allows them to command a premium multiple.
While something like this isn’t within your control, what is within your power is knowing the conditions in which you’d sell your business to achieve the best result.
Key takeaway: Business valuation can involve a stroke of luck. Control the factors you can to command a premium.
How to implement: Create a detailed exit strategy that outlines when and under what circumstances you would consider selling your business for maximum value.
The factors that drive your business valuation are multifaceted, combining both internal and external elements. To maximise your business’s value, continually focus on improving your margins, explore growth opportunities, optimise profit efficiency, reduce owner dependency, stay informed about industry trends, consider the economic conditions, and position your business to be in the right place at the right time.
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