Whether it’s because you’re planning to sell your business, you’re looking for investment to take things to the next level, or to stimulate underperforming management, an accurate estimation of a business’ value is beneficial for several reasons.
Whatever your reasons, you want to reach a valuation that doesn’t end up selling the business short, or overstate the business’ actual worth. It can be tough to find a balance, which means you might have to combine a few different valuation techniques. Here, we’ll illustrate a variety of different valuation methods and their applications, as well as the factors that can end up affecting the value of your business.
As we’ve mentioned, there are lots of reasons an owner may want to value their business. Outside of buying or selling, these include:
While every business will have tangible assets, like premises, stock or equipment, that can be easily valued, there are also intangible assets which can affect its value. Before conducting a valuation, consider the following:
While these intangible assets make it harder to reach an accurate valuation, there are several techniques you can use to make it easier.
Price to earnings ratio
One of the more common methods, businesses are often valued by their price to earnings ratio (P/E), or multiples of profit. Best suited to businesses with an established track record of profits, arriving at the number for your P/E ratio can vary depending on the business. Tech start-ups often have a high ratio since they’re high-growth companies. Something l
If your business receives a P/E ratio quote, it tends to be easier to buy and sell, making them highly attractive to investors. Smaller, unquoted companies usually have around a 50% lower P/E ratio than those who have been quoted.
Since they differ so much, there isn’t a standard ratio that can be used to value all businesses; a business advisor will typically suggest a valuation of 4:10 as a P/E ratio.
How much would it cost to set up a similar business to the one being valued? This is what the entry method entails. To get this figure, you’ll need to factor in the things it took for you to get the business where it is today. Note all the start-up costs, followed by its tangible assets. How much would it cost to develop any products, build up a customer base, and recruit and train staff?
To reach a valuation, you should also think about the savings you could make when setting up this hypothetical new business. If you can save by locating the business somewhere else or by using cheaper materials, then subtract these from your figure.
After all these things have been considered, you’ll have your entry cost, plus a valuation for your current business.
If you’re a business with sizeable tangible assets, then asset valuation may be the approach for you. As we mentioned earlier, a tangible asset is any asset with a physical form, such as land, buildings, machinery and inventory.
To carry out an asset valuation, you’ll need to work out the Net Book Value (NBV) of the business, i.e. the total assets minus the total liabilities (a business’ legal financial debts or obligations – such as loans, mortgages and accrued expenses). These are the assets recorded in the company’s accounts, though you’ll need to factor in things such as inflation and any appreciation or depreciation to make sure any asset values are up to date
This valuation method produces the lowest value for a business since it assumes the business doesn’t have any goodwill. Goodwill is defined as the difference between a company’s market value (what people are willing to pay for it) and the value of its net assets (assets minus liabilities).
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One of the more complex ways of valuing a business, this method relies on assumptions about a business’ future. Suited to mature businesses with stable, predictable cash flows, such as utilities companies, the approach works by estimating what future cash flow would be worth today.
This is done by the sum of the dividends forecast for each of the next 15 or so years, plus a residual value at the end of the period.
Today’s value of each future dividend is calculated by applying a discount interest rate (typically, anything from 15% to 25%), which takes into consideration the risk and the time value of money (based on the idea that £1 received today is worth more than the same amount received tomorrow). If the estimated value is higher than the current cost of investment, the likelihood is that the investment opportunity is a sound one.
Industry rules of thumb
Each sector has a standard formula which can be used to value businesses that operate within it. For instance, retail organisations are normally valued as a multiple of turnover, volume of customers or number of outlets. Elsewhere, computer maintenance and mail order businesses are almost exclusively valued by turnover; mobile phone airtime providers by the number of customers, and estate agency businesses by the number of outlets.
Valuing what can’t be measured
Here’s where the intangible assets we mentioned before come into play. A business can only be worth what someone is willing to pay for it, and intangible assets – as well as some canny negotiating skills – can affect the final number.
For instance, if the business has strong relationships with customers or suppliers, it might be more valuable to a buyer. Likewise, if the buyer lacks a stable team behind them to take the business forward, a strong management team might benefit the value. Every buyer will be different, with their own views on what may and may not be risks. As a business owner, then, the key is to pre-empt any potential risks and minimise them beforehand.
Another point we raised earlier is how valuations can help you to see which areas need improving. Through doing the following, you can optimise your chances of securing a good valuation:
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