The need for valuation of a business has impacted companies nationally as well as internationally. The rapid globalisation in the world economy has opened up more opportunities but has simultaneously made it complex for companies to justify their valuation.
Company Valuation, in simple terms, means the process of determining the ‘Economic Value’ or ‘Economic Worth’ of a company. It is based on internal and external environment and is backed by empirical reasons and evidence.
Need for Company Valuation
Valuation is a noteworthy component of the financial system and is required for several reasons. Inheritance, selling of the business/company, lawsuits, partnership, purchase of a property, mortgage, etc. are a few circumstances that demand company valuation.
There are various methods calculated and several approaches made to determine the fair value of a company.
Often, the valuation of a company is done on the basis of the following 3 methods –
- Market-based approach
- Asset-based approach
- Income-based approach
In some cases, the company valuation is performed through all the three approaches and an average solution is taken into consideration. However, there are a number of factors such as purpose, management, industry, etc. whether you are selling your business or not, increasing its value becomes difficult.
1. Improved Cash Flow – Cash flow is the most important factor driving to the value of a company. In case if the company is being sold or acquired by another entity, the buyer company will look for companies that have an increasing cash flow, year after year.
- Firstly, buyers pay more emphasis to the future growth of a company. While valuation, buyers calculate the estimated cash flow and the risk attached to generate the cash flow. A track record of sustainable cash flow exhibits high potential in such companies post sales also.
- Secondly, a sustainable increase in the cash flow not only describes the potential of a company’s product/service but also validates the team capacity to drive growth.
2. Diversified Customer Base – To a large extent, companies generally earn more revenue from some selected customers. These specific customers account for nearly 8-10 per cent of the company’s total sales. Hence, losing even a single customer out of this list may seriously risk a company’s earnings and hurt the company’s value. The key is to diversify the customer concentration – Reduce the entire focus on these customers and spread it across the complete customer base. It will increase future dependency on varied avenues and aid in increasing the company’s valuation.
For business sales or acquisition, buyers will focus on the top 10 per cent of revenue generating customers. So, to increase the company’s overall value, it is a must to have relationships in place with important customers and diversify customer concentration.
3. Accuracy in Books of Accounts – An accurate record of the company’s information and financial statement are the major determinants to evaluate company’s present as well as future performance. Moreover, organised books of accounts also indicate the effectiveness in the management of the company.
Under significant events such as mergers & acquisitions, partnerships, etc. financial statements are of paramount importance. Under the due diligence process of business selling, financial statements are analysed in depth. Hence, books of account must be accurately maintained and kept up-to-date.
A well-organised historic financial statement indicates system management and a consistent increase evident in sales and revenue figures adds weight to company valuation.
4. The Quality of the Company’s Earnings – Revenue earned by the company due to an increase in sales or a reduction in cost is quality earnings of the company. It is a prime area where a buyer looks at the time of company valuation. If you focus on quality earnings and bring a marginal change in quality earnings, it will bring a shift in the company’s valuation.
5. Efficient Systems and Controls – Systems and management control ensure that the entire procedure of the company is in place. It also indicates that the company is practising risk management and the resources are being efficiently utilised. Moreover, a general idea that the company operates in compliance with the law is also indicated. Documenting every process will acknowledge a potential buyer and give him the confidence that the company is in a good condition.
6. Scalable Business – Scalability has a crucial role in better customer service and employee participation. The valuation of a company is higher if it invests in serving customers, improving products, and handles complaints in a better way. If the processes of the company are scalable, it becomes easier to hire and train employees and resultantly render better service to customers. Besides a smoother functioning in the company, if employees are given the freedom to document and refine systems, the ability of the company to grow quickly increases.
7. Intellectual Property – Intellectual property includes patents, copyrights, trademarks and so on. Authorising intellectual property helps the company to sell its products and services at a higher price. Hence, the company can have a higher valuation and have better positioning in the market.
8. Capital Structure – A company’s capital structure comprises of debt and equity. Higher debt means the company needs funds for cash flow and meeting its operation and expenditure, which negates the company valuation. Whereas if a company owns a high amount of shares, it determines the growth of the company.
9. Reduced Overheads – When determining the value of a company, the viewer will always look for increased profitability. But how can a business boost profitability? Here it is –
Implementing processes that increase efficiency
- Cost cut
- Reduction in overheads
- Higher profitability leads to higher company valuation and also exhibits that the company operates efficiently
10. Competitive Advantage – Competitive advantage is the main reason buyers approach you instead of other suppliers. You may be selling products at a better price or of a premium quality that makes buyers turn to you instead of your competitors. It is one of the most convincing value drivers. And even if you do not have a competitive advantage, it is worth paying attention and investing time on value drivers.
You can discuss and discover your competitive advantage with your management team. Once you are sure about your competitive advantage, create strategies to protect and promote it.
Why?
Competitive Advantage is a factor that improves the value of the company and cajoles buyers to invest more in a company.
All in all, it is advisable to regularly observe your company’s valuation. To ensure transparency and attain a fair value of company valuation, it is inevitable to consider all the factors. The trick is to emphasise on the above mentioned 10 valuable driving factors for company valuation.