How to value a business: 5 methods for realistic estimations

Whatever the reason, putting a number on your organisation’s worth can be highly beneficial – here’s how to do it right.

18 November 2019

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.

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What can be gained from valuing 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:

  • Investment purposes: a valuation can help with settling on a price for issuing new shares
  • Developing an internal market for shares: valuing a business helps to trade shares in a business at a reasonable price
  • To stimulate management: If you feel management is under-performing, a valuation can serve to focus their attention and efforts, or reward those who go the extra mile

Employees discussing business value

What can affect a business’ value?

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:

  • The business’ reputation
  • The value of the business’ customers
  • Any trademarks you hold
  • Any circumstances surrounding the valuation, such as when the business is forced to sell
  • How old the business is
  • The kind of products you have

While these intangible assets make it harder to reach an accurate valuation, there are several techniques you can use to make it easier.

How do you value a business: Methods of evaluation

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

Bank manager and farmer discussing costs

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.

Entry cost

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.

Share options for businessAsset valuation

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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Discounted cashflow

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.

Business owners discuss sales optionsThis 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.

valuing a small business

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.

Effective methods to improve valuation accuracy?

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:

  • Planning ahead: Create a solid business plan, with a focus on how you’re going to achieve both short-term and long-term results. Click here for an effective guide to building your business plan.
  • Reducing risk: If you rely on a certain group of customers, you may be limiting yourself, so consider diversifying.
  • Putting processes in place: Consider how you store information, whether it’s financial records or simply how the business works. The more information you can show in this regard, the greater confidence you can have in your business.

Gazprom Energy is a leading and award-winning business energy supplier, helping thousands of small businesses manage their gas and electricity contracts. To find out more about what we can offer your business, visit the homepage or call us today on 0161 837 3395.

The views, opinions and positions expressed within this article are those of our third-party content providers alone and do not represent those of Gazprom Energy. The accuracy, completeness and validity of any statements made within this article are not guaranteed. Gazprom Energy accepts no liability for any errors, omissions or representations.

 


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