From the JPAbusiness Strategic Business Insights blog archives
In this blog James explains how a business's online presence is assessed during the business valuation process. He also explains how 'online' factors - such as size and quality of a database - fit in with general business health factors when gauging a business's value.
Google receives the ultimate compliment
When we look at the value of a business today, one of the things we consider is the extent to which the business – the name, brand and services – is known by audiences.
That audience must be relevant to the service the business is providing and may contain existing customers or potential new customers.
Google is an example of a business that has received the ultimate compliment from its audience in terms of business valuation.
When people think of ‘Google’ they’re generally not thinking of it as the name of a business; in the psyche of customers ‘Google’ means a search process or tool i.e. ‘I’ll just google that...’
In my book, that’s the ultimate compliment and the ultimate tick to a business valuation: when customers use your name to describe their behaviour.
Valuing an online business
Valuation is not an exact science. There is a degree of objectivity and market comparison regarding a valuation assessment, but there’s also a degree of emotion and subjectivity around it.
After all, beauty is in the eye of the beholder.
These days online companies have added another layer of complexity to business valuations and it is a tricky area, because there is some subjectivity and future projections involved in people’s behaviour in the online space.
However, generally customers are becoming increasingly sophisticated in the way they seek and share information online to determine whether they wish to buy a product or service, or recommend one, and we can use this behaviour to inform our valuations.
Gauging a business’s online position
These days when we value a business in any industry we consider the usual elements such as physical location, customer base, product offering, point of difference, financial and business performance, people and so on, but we also look at how they are positioned online.
Their online ‘position’ includes:
- What people are saying about them, as well as what they’re not saying about them
- How high they rank in organic searches
- If there are positive or negative reviews about their services
- How frequently they appear in relevant searches or, if they don’t appear, which of their competitors appear
- The size and activity of their online database.
Database – key component of value, online and off
One of the components of a business valuation is a database of prospects and customers, which signifies the potential of a business in terms of prospects the business may have to transact with into the future.
A large database is often held up by a business vendor as proof of value and goodwill.
Size doesn’t matter? Well actually it does, but quality wins every time!
In terms of business value we don't just look at the size of the database, but also the quality – the actual users of the product or service – because that interaction is a direct proxy for what the database thinks about the business’s offering.
Quality database ranks high in online space
Online businesses are often valued more on the size of their database and regularity of those users interacting with the content or product and service offered, than the actual financials of the business.
Valuing 101: Understanding earnings multiples
We’ve talked about this in previous blogs, but businesses are typically valued using:
- A discounted cash flow analysis, or
- A multiple of business maintainable earnings (BME), or
- Net tangible assets of the business.
In the first two, and particularly with multiple of BME, the market will normally say there’s a range of earnings multiples.
For a small to mid-sized private business that is an add-on type business, the multiples may range from 1.5 to 4 times BME.
So we can say: “Clothing Shop A has BME of $300,000 per annum and, as we know that like businesses have sold in a range, we think the value is somewhere between 2.1 and 2.8 times BME.”
The difference between 2.1 and 2.8 is a big number – in this case it’s 0.7 times $300,000, which is $210,000.
So how do we determine the value – is it 2.1 or 2.8?
Assessing business health factors
In order to determine value we need to assess the business health factors, which may include:
- Size and quality of database
- Online presence and quality of online interaction
- Physical location
- Quality of financial earnings (steady or fluctuating over past three years)
- Diversity of clients
- External pressures on industry
- Point of difference
- Future projections and prospects.
These business health factors are about asking: ‘If I take over this business today is it healthy, or will it catch a cold in the first 30 days?’
If Clothing Shop A had a 2000-strong database and 500 were regular users who spent over $150 each year, that would be a tick in terms of health factor.
That, in isolation, would move the multiple of that business closer to the 2.8 times than 2.1 times BME.
But you need to think of each health factor on a sliding scale, each sliding between 2.1 and 2.8.
Beauty is in the eye of the beholder
While each health factor moves along a sliding scale, they will also be ranked in different orders of importance by different potential buyers.
The reason there are values in the market that don’t seem to add up is that some buyers will place a much higher value ranking on certain health factors than others.
When we do a valuation for a client looking to sell their business, we try and make assumptions about the target market for the business and what those potential buyers will be looking for.
We ask ourselves ‘which health factors are of most importance to potential buyers?’:
- Will they be looking at this purchase as an add-on business, which means a seamless transfer and synergies is most important?
- Or would it better suit a stand-alone business operator who would be more interested in their likely rate of return?
Originally posted by James Price on June 16, 2014.
James Price has over 30 years' experience in providing strategic, commercial and financial advice to Australian and international business clients. James' blogs provide business advice for aspiring and current small to mid-sized business owners, operators and managers.