Valuing your business

There are many rea­sons why you may need to cal­cu­late the val­ue of your busi­ness. Here we con­sid­er the range of meth­ods avail­able as well as some of the fac­tors to con­sid­er dur­ing the process.

It is impor­tant to remem­ber through­out that valu­ing a busi­ness is some­thing of an art, albeit an art backed by sci­ence!

Why value your business?

One of the most com­mon rea­sons for valu­ing a busi­ness is for sale pur­pos­es. Ini­tial­ly a val­u­a­tion may be per­formed sim­ply for infor­ma­tion pur­pos­es, per­haps when plan­ning an exit route from the busi­ness. When the time for sale arrives, own­ers need a start­ing point for nego­ti­a­tions with a prospec­tive buy­er and a val­u­a­tion will be need­ed.

When a busi­ness needs to raise equi­ty cap­i­tal a val­u­a­tion will help estab­lish a price for a new share issue.

Valu­ing a busi­ness can also help moti­vate staff. Reg­u­lar val­u­a­tions pro­vide mea­sure­ment cri­te­ria for man­age­ment in order to help them eval­u­ate how the busi­ness is per­form­ing. This may also extend to share val­u­a­tions for entry into an employ­ee share option scheme for exam­ple, again used to moti­vate and incen­tivise staff.

Valuation methods

While there is a ready made mar­ket and mar­ket price for the own­ers of list­ed pub­lic lim­it­ed com­pa­ny shares, those need­ing a val­u­a­tion for a pri­vate com­pa­ny need to be more cre­ative.

Var­i­ous val­u­a­tion meth­ods have devel­oped over the years. These can be used as a start­ing point and basis for nego­ti­a­tion when it comes to sell­ing a busi­ness.

Earnings multiples

Earn­ings mul­ti­ples are com­mon­ly used to val­ue busi­ness­es with an estab­lished, prof­itable his­to­ry.

Often, a price earn­ings ratio (P/E ratio) is used, which rep­re­sents the val­ue of a busi­ness divid­ed by its prof­its after tax. To obtain a val­u­a­tion, this ratio is then mul­ti­plied by cur­rent prof­its. Here the cal­cu­la­tion of the prof­it fig­ure itself does depend on cir­cum­stances and will be adjust­ed for rel­e­vant fac­tors.

A dif­fi­cul­ty with this method for pri­vate com­pa­nies is in estab­lish­ing an appro­pri­ate P/E ratio to use — these vary wide­ly. P/E ratios for quot­ed com­pa­nies can be found in the finan­cial press and one for a busi­ness in the same sec­tor can be used as a gen­er­al start­ing point. How­ev­er, this needs to be dis­count­ed heav­i­ly as shares in quot­ed com­pa­nies are much eas­i­er to buy and sell, mak­ing them more attrac­tive to investors.

As a rule of thumb, typ­i­cal­ly the P/E ratio of a small unquot­ed com­pa­ny is 50% low­er than a com­pa­ra­ble quot­ed com­pa­ny. Gen­er­al­ly, small unquot­ed busi­ness­es are val­ued at some­where between five and ten times their annu­al post tax prof­it. Of course, par­tic­u­lar mar­ket con­di­tions can affect this, with boom indus­tries see­ing their P/E ratios increase.

A sim­i­lar method uses EBITDA (earn­ings before inter­est, tax, depre­ci­a­tion and amor­ti­sa­tion), a term which essen­tial­ly defines the cash prof­its of a busi­ness. Again an appro­pri­ate mul­ti­ple is applied.

Discounted cashflow

Gen­er­al­ly appro­pri­ate for cash-gen­er­at­ing, mature, sta­ble busi­ness­es and those with good long-term prospects, this more tech­ni­cal method depends heav­i­ly on the assump­tions made about long-term busi­ness con­di­tions.

Essen­tial­ly, the val­u­a­tion is based on a cash flow fore­cast for a num­ber of years for­ward plus a resid­ual busi­ness val­ue. The cur­rent val­ue is then cal­cu­lat­ed using a dis­count rate, so that the val­ue of the busi­ness can be estab­lished in today’s terms.

Entry cost

This method of val­u­a­tion reflects the costs involved in set­ting up a busi­ness from scratch. Here the costs of pur­chas­ing assets, recruit­ing and train­ing staff, devel­op­ing prod­ucts, build­ing up a cus­tomer base, etc are the start­ing point for the val­u­a­tion. A prospec­tive buy­er may look to reduce this for any cost sav­ings they believe they could make.

Asset based

This type of val­u­a­tion method is most suit­ed to busi­ness­es with a sig­nif­i­cant amount of tan­gi­ble assets, for exam­ple, a sta­ble, asset rich prop­er­ty or man­u­fac­tur­ing busi­ness. The method does not how­ev­er take account of future earn­ings and is based on the sum of assets less lia­bil­i­ties. The start­ing point for the val­u­a­tion is the assets per the accounts, which will then be adjust­ed to reflect cur­rent mar­ket rates.

Industry rules of thumb

Where buy­ing and sell­ing a busi­ness is com­mon, cer­tain indus­try-wide rules of thumb may devel­op. For exam­ple, the num­ber of out­lets for an estate agency busi­ness or recur­ring fees for an accoun­tan­cy prac­tice.

What else should be considered during the valuation process?

There are a num­ber of oth­er fac­tors to be con­sid­ered dur­ing the val­u­a­tion process. These may help to great­ly enhance, or unfor­tu­nate­ly reduce, the val­ue of a busi­ness depend­ing upon their sig­nif­i­cance.

Growth potential

Good growth poten­tial is a key attribute of a valu­able busi­ness and as such this is very attrac­tive to poten­tial buy­ers. Mar­ket con­di­tions and how a busi­ness is adapt­ing to these are impor­tant — buy­ers will see their ini­tial invest­ment realised more quick­ly in a grow­ing busi­ness.

External factors

Exter­nal fac­tors such as the state of the econ­o­my in gen­er­al, as well as the par­tic­u­lar mar­ket in which the busi­ness oper­ates can affect val­u­a­tions. Of course, the num­ber of poten­tial, inter­est­ed buy­ers is also an influ­enc­ing fac­tor. Con­verse­ly, exter­nal fac­tors such as a forced sale, per­haps due to ill health or death may mean that a quick sale is need­ed and as such low­er offers may have to be con­sid­ered.

Intangible assets

Busi­ness val­u­a­tions may need to con­sid­er the effect of intan­gi­ble assets as they can be a sig­nif­i­cant fac­tor. These in many cas­es will not appear on a bal­ance sheet but are nev­er­the­less fun­da­men­tal to the val­ue of the busi­ness.

Con­sid­er the strength of a brand or good­will that may have devel­oped, a licence held, the key peo­ple involved or the strength of cus­tomer rela­tion­ships for exam­ple, and how these affect the val­ue of the com­pa­ny.

Circumstances

The cir­cum­stances sur­round­ing the val­u­a­tion are impor­tant fac­tors and may affect the choice of val­u­a­tion method to use. For exam­ple, a busi­ness being wound up will be val­ued on a break up basis. Here val­ue must be expressed in terms of what the sum of real­is­able assets is, less lia­bil­i­ties. How­ev­er, an on-going busi­ness (a ‘going con­cern’) has a range of val­u­a­tion meth­ods avail­able.