Valuation
What Factors Impact Business Valuations?
By Lee Smith · · 5 min read · Updated
Valuation is a fundamental principle of finance, and one that employs an entire investment banking industry. Yet it is a nuanced process where five different people can produce five different results. In that sense, valuation is as much an art as a science.
Nonetheless, there are several fundamental factors that drive it. If you are thinking of buying or selling a business, valuation is a key consideration, and for good reason. Overpaying dilutes earnings and shareholder value. Selling for a lower multiple than the business deserves means leaving money on the table. To avoid either, focus on the following.
1. Earnings history
Evaluating the quality and stability of earnings over the past three to five years helps assess the forward-looking value of a business. Past performance is not necessarily indicative of future results, but it is a sound foundation.
Positive growth and consistency in gross income, earnings and free cash flow support a valuation. Declining or volatile earnings depress it. This is why we ask for three years of accounts before we put a number on anything.
2. Growth prospects
Growth potential is highly subjective but critical. It can come from the industry the company sits in, or from the business's own characteristics.
A business in a growing market, such as commercial heat pumps or battery storage, will typically fetch a higher multiple than one in a declining industry. A business with barriers to entry, such as accreditations, framework positions or long-term maintenance contracts, is attractive for the future growth it protects.
3. Diversification
Diversification takes a number of forms: customer, geographic and product. By diversifying, a business lowers its exposure to any single variable.
Customer concentration is the one buyers worry about most. Relying on a small number of clients for a disproportionate share of revenue is a risk, because losing one client materially hits the top line. Geographic diversification protects against a downturn in one market, and product diversification hedges against one service becoming obsolete. The better the spread across customers, suppliers, markets and products, the better the multiple a buyer will pay.
4. Reputation
A company's reputation within the broader community lifts multiples. A strong brand and a trustworthy management team and workforce represent the company positively to every external stakeholder.
If a buyer is convinced they are gaining a powerful brand and strong people, they will pay more. It is also why we keep the name over the door. The reputation is part of what we are buying.
5. Capital allocation track record
Over the life of a business, management makes acquisitions and large capital expenditures on property, plant and equipment. Depending on how those decisions affected revenue and earnings, they raise or lower the valuation.
Poorly executed capital allocation leads to increased debt and reduced cash. Sound capital allocation grows enterprise value over time. Prudence here grows equity value and attracts higher multiples.
What this means for you
At Verdani Capital, legacy for employees and brands matters. Our mission is to build on your already successful business and create long-term value for everyone involved.
For a first view on what your business might be worth, use our valuation guide, or contact us for an unbiased valuation.
Related reading: The 5 pitfalls of business broker valuations · How we buy
Questions this article answers
What factors affect the valuation of a business?
Five fundamentals drive most business valuations: the quality and stability of earnings over three to five years, growth prospects, diversification across customers, geographies and products, reputation and brand strength, and the track record of capital allocation. Businesses that score well on all five attract higher multiples.
Why does customer concentration reduce a business valuation?
Relying on a small number of clients for a large share of revenue is a risk to the buyer, because losing one client can materially hit revenue. Buyers price that risk in with a lower multiple. Spreading revenue across more customers, regions and services supports a higher valuation.