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What is the value of a business?

Without delving into a detailed technical description of a business valuation ( see links at the end of this section ) the value of a business might be described as the sum of it’s asset value and it’s potential value.

Included in asset value are things like sales ( per annum ), revenues ( invoices ), gros and net profits, business assets ( buildings, equipment and goodwill ). It is typical to value a business as a multiple of revenue or profits with comparisons to other, similar, businesses. Recurring or contracted future revenues are very attractive ( the tighter the contracts the better ).

Potential value is harder to define but includes the potential to grow ( perhaps globally ), scale and replicate. “ Dotcom “ companies like Google and Facebook are perhaps considered to have had relatively small revenues and little or no profits but had and have huge “ potential value “. There also may be an element of potential value existing because no one quite understands what the actual final potential is.

The actual value of one company to another depends very much on the situation of each company separately and in relation to one another. One company may value a company higher than another because it is a “ better strategic fit “ or is perceived to add greater value or because the actual valuation metrics used ( by the acquirer or their accountants ) are different.

We must not forget that emotional  factors can also play a part. Companies can attract higher valuations because “ a company does not want a competitor to get them “ or even because “ they just want them “ for some reason.

( For these and other reasons NEVER have one potential bidder. ALWAYS seek others ).

The value may be related to what is happening in the market now but, if the acquirer has done their own strategic planning well, is more likely to be about the value in the future.

It may be useful to understand here the concept of “ leverage “, which whilst having many uses and meanings, we use to describe value creation. For example a product may be bought in at a certain price, “ value “ added, marked up and sold on at a higher price. The original sum paid for the product has been “ leveraged “  creating sales, revenues and profits.

The concept also applies to money being borrowed for business use. i.e. £100K is required. £30K is provided by the borrower and the bank provides £70K. So £100K is borrowed for a £30K contribution and then interest ( and perhaps capital ) is paid back over time. That £100K is  used to buy e.g. products  as previously and revenues and profits are generated that allow repayments to be made.

The amount of borrowing related to the worth of the company is the “ gearing “ ( ratio of debt to worth ). The correct or optimum amount of gearing is a subject of some considerable debate and difference of opinion but there are those people who will say that too low gearing can be as bad as too high gearing and that as long as you can make the repayments ( by generating appropriate revenues, profits and cash ) then the upper limit of gearing could be very high e.g. 90%

Useful links.

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