How to Value an SME?

Small business valuation is the process of identifying an SME’s true worth or value based on its assets, earnings, growth potential, and other factors. Why SME valuation is required? Well, valuing your company is crucial for many events - raising funds from private investors, going public via SME IPO, or merger and acquisition. Right valuation is important when an SME is considering raising funds through public issues to fix the right price for the shares, which leads to a successful IPO. The lead manager/merchant banker assists SME promoters and founders in ascertaining the company's true worth.

However, company valuation is a complex process that requires a critical understanding of the company’s financial performance, legal and regulatory environment, future growth prospectus, and other external qualitative factors.

So, given the complexities around valuation, the big question is how to value an SME. There are various methods out there, including asset-based method, earnings-based method, and market multiple approaches to determine the worth of your company.

Let’s understand each of these methods in detail for company valuation;

SME Business Valuation Methods

Here are some common valuation methods that promoters can use to value their company;

1. Income-Based Valuation Approach - Discounted Cash Flow (DCF) Method

This is the most widely used method for company valuation. The income-based approach of valuation takes into account future business income or cash flows for valuation.

How to determine SME value via the DCF method;

• Cash Flow projection: At first, you have to make future projections about cash flows. Yes, an entrepreneur with financial advisors analyzes past cash flows to predict anticipated cash flows for the coming period, say 3 or 5 years.
• Discount Rate: Use an appropriate discount rate which can be a small business interest rate or weighted average cost of capital means the expected return rate.
• Present Value of Cash Flows: The discount rate is used to calculate the present value of projected cash flows and the terminal value at the end. Discounting is done to adjust against the risk that actual cash inflows may vary from the projections.
• Once the company value is determined, cash is added and the amount of debt funding is subtracted to identify the value of equity.

2. Asset-Based Valuation Method – Net Asset Value Method

As the name suggests, the asset-based method of small business valuation uses business assets and liabilities to determine the net value.

• Calculate the fair value of all the business assets it has.
• In case of depreciating assets such as plant and machinery, furniture & fixtures, etc., start with the purchase price of assets and then subtract the value of depreciation through its use.
• Also, determine the fair value of non-depreciating assets. Though there is no depreciation consider fair value as the realization value that you will receive in the event of sell.
• Calculate the Net Asset Value by subtracting the sum of total SME liabilities from the total fair value of assets in the balance sheet

NAV = Total of the company Assets – Sum of outstanding business liabilities

3. Market-Based Approach - Comparable Company Analysis for Valuing an SME

In this method of valuation, what managers do is they analyze the valuation of peer companies and apply the valuation metric to their own company to estimate the value. This is a market-based valuation approach also termed a relative valuation method.

1. Firstly, SMEs have to identify comparable companies or peers who are operating in the same industry, similar in size to that of the target company, and have comparable growth outlook. Selecting the right companies for benchmarking is important otherwise it can significantly affect your valuation.
2. Once you have selected the group of peer companies for comparison, check for key valuation multiples, including price-to-earning ratio (P/E), price-to-sales (P/S), and price-to-book value (P/BV).
3. Apply comparable peer’s valuation ratio to the target SME’s financial outcome – sales, earnings, etc. to determine the company’s worth

Key Comparable Metrics used in the Market Valuation Approach are;

1. Price to Earning Ratio, is derived by dividing the stock’s market price by the earnings per share.
2. The price-to-sales ratio is calculated by dividing the company’s market capitalization by the total sales.
3. Price to book value is determined by dividing the market price of the share by its book value.
4. EBITDA to sales ratio comes by dividing the company’s total operating profit by the net sales.

The success of a comparable valuation method depends upon the right selection of peers.

Tips: How to select comparable companies for SME valuation?

Keep a check on important factors while selecting peers for comparison;

1. Industry or sector, peers are operating in.
2. Size in terms of revenue, assets, or employee base
3. The growth rate of the comparable company
4. Peer margins and profitability ratios

If all these factors resonate with the target company can be considered a good fit for comparable valuation.

Importance of Valuation for SME IPO

Valuation and pricing is a success factor for SMEs planning to raise funds via IPO. Appropriate SME valuation adds to SME IPO success. Let's understand how;

Undervaluing an SME with low issue prices affects long-term success and your stock performance. However, overpricing an IPO halts the demand for the public issue and thus, listing success.

Investment banker, as a valuation expert, helps SMEs with an accurate valuation. Approach the right merchant banker that has expertise in the industry, you are operating in.

Best SME IPO Merchant Banker (Link)

What are the Key Steps in the SME Valuation Process?

The process of valuing an SME follows several crucial steps, including;

1. Gather required financial information: The business valuation process requires experts to collect essential data from the financial statements – income statement/P&L, balance sheet, and cash flow statement. While valuing an SME through any method, you need quantitative data, such as revenues, profitability, assets, liabilities, cash flow, etc. Also, you may have to adjust for non-recurring expenses that are not a part of everyday business activities i.e., owner’s compensation, equipment purchase, etc.
2. Select the right valuation method: Among various valuation methods, select the one that fits your business nature. You are free to select one or more methods to value your SME.
3. Application of the selected method: Use relevant data from financial statements to calculate the desired outcome say net asset value, or project future cash flows, etc.
4. Adjust for Qualitative Factors: Do not neglect external qualitative factors i.e., the company’s customer base, market position, and growth potential. Also adjust for market conditions, competition, regulatory environment, operational challenges, and market trends.
5. Analyze valuation results: If you have used multiple valuation methods, compile and review different valuation results to reach to a final valuation outcome.
6. Documentation: Finally, prepare a detailed valuation report outlining the valuation method used and key assumptions.