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Sunday, September 03, 2006

How much is your business worth?

If you're enticing a new investor, selling your business, joining another or looking to get insurance coverage, it's always best to have your business appraised. You never know how much good it would do to you and your business.

By Henry Ong

In today's rapidly changing business environment, certain situations force entrepreneurs to find out their businesses' market value. These arise when the entrepreneur faces ownership problems - as in joint ventures - or if he's thinking of selling the business, merging with another, or attracting new investors. Going off tangent with a business valuation could lead to serious problems in the future, and any forward-looking entrepreneur would do well to determine how much his business is worth to give him a solid ground to stand on.

Disagreements over the business's actual price tag could make or break a potential deal. Because a private company doesn't have the transparency enjoyed by companies listed in the Philippine Stock Exchange whose share prices are publicly known, it needs a careful and accurate valuation of its worth to establish a fair and reasonable share price that becomes the baseline reference for negotiation.

Another use for valuation is when the entrepreneur is getting insurance for his business. A fire gutting a retail store, for example, causes a business owner to incur additional losses if his business were valuated improperly. It may turn out that the insurance coverage is only P500,000 for a business that is valued at P3 million, or the reverse: the business is insured for P3 million when it is valued only at P500,000.

Two of the most common approaches in business valuation are the earnings multiple method and the discounted cash flow model. In the earnings multiple method, the valuation is based on the business's earning potential. The appraiser gets the average net income for a number of years and multiplying the quotient with a benchmark Price-Earnings (P/E) ratio. The valuator gets the P/E ratio from market comparables such as a recent transaction of a similar business or the average P/E in the stock market.

For example, a coffee shop owner is planning to sell his business to a competitor. The average business's annual net income in the last five years is P500,000. The appraiser determines that the average P/E ratio of retail food companies in the stock exchange is 10x. The coffee shop's value is estimated at P5 million, which is computed as P500,000 average annual earnings multiplied by 10x P/E.

With the discounted cash flow model, the appraiser computes the present value of all the cash flow the business will generate over a given number of years. The cash flow's present value will depend on the appraiser's assumed discount rate. When the business is risky, the discount rate used is normally high, and the result is a low present value. When the business is stable, the discount rate is low, while the present value is high.

For example, a computer business is estimated to generate P1 million in total cash flow in the next five years. By discounting all the cash flows, the appraiser determines that its present value is only P500,000 given the uncertainties in the economy, and P700,000 under the best scenario.

These methodologies are used when the business is assumed to be a going concern at the time of its sale. The resulting valuation is called fair market value or intrinsic value, which is above the book value (residual value after total liabilities are deducted from total assets) of the business. The excess amount pertains to the intangibles or goodwill of the business, which could be due to the strong location of the company's outlets, brand name, management team or technology.

The methodology is different when the business has stopped operating. To determine its value, estimate the proceeds of the sale of all its assets and use this to pay off all payables and debt, including estimated cost of liquidation. For example, an owner of a franchised laundry business has decided to close shop. His appraiser computed that out of the total P100,000 accounts receivable, only P50,000 can be collected. This amount is added to the P25,000 the business has in the bank, for a total of P75,000. He then uses this amount to pay the P35,000 in total liabilities and P15,000 in liquidation cost, so the business's net liquidation value is P25,000.

It's always wise to hire the services of a certified public accountant with experience in appraising businesses when you want to know your company's worth. One can also hire the services of a Certified Financial Consultant who has specific training in corporate finance and valuation. Engaging the services of a professional appraiser will result in an objective and unbiased estimate of a business's value. The appraiser's fee may depend on the work scope and the business's complexity.

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