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.