How to value a business: 5 methods for realistic estimations

Whether you’re selling or investing, determining business value can be a fine art. Here’s what you need to know…

10 April 2019

Whatever side of the deal you’re on, valuing a business can be a tricky process, so it’s tough to know where to start with things. The amount of time and energy business owners put into their venture means it’s important to approach valuing the operation in the right manner. 

Whatever the reasons for determining the worth of a business, help the process go as smoothly as possible with these helpful steps. We’ll be touching on the methods of evaluation, the factors that commonly affect the process and how it can improve areas of the business going forward. 

Why should you value your business?

As well as buying or selling a business, some other common reasons for valuation include:

  • Investment purposes: determining the value assists with settling on a price for issuing new shares.
  • Developing an internal market for shares – looking to trade shares in a business at a reasonable price? Valuation can help with that.
  • Stimulating management – a valuation may serve to focus the attention and efforts of under-performing management, or alternatively, reward those who have exceeded their performance.

Employees discussing business value

Methods of evaluation

  • Price to earnings ratio

If your business has a proven track record when it comes to profitability, then the price to earnings ratio method would be a suitable method. The technique involves three elements:

  • Adjusting monthly or annual profits to exclude one-off purchases and costs to provide a picture of future profits further down the line.
  • Adding further costs or gains the company stands to make after it has been sold or invested in, which results in a final profit figure called the normalised figure.
  • Multiplying normalised profit by three to five times, which is an industry standard practice.

The end figure is your business’ price to earnings ratio.

  • Asset Valuation

This is the process of valuing the business based upon what it physically owns. 

Businesses with large physical assets, such as land, buildings, machinery and inventory, are well suited to the asset valuation method. Conversely, businesses with intangible, non-physical assets, like brand recognition and intellectual property, would not be suited to this approach.

The accounts will show the net value of the business i.e. total assets minus total liabilities – though they may not factor in things such as inflation, appreciation or depreciation, so you’ll need to be sure that all asset values are up-to-date.

Bank manager and farmer discussing costs

The asset valuation method tends to produce the lowest value for a business because it assumes that the business doesn’t have any goodwill, another intangible asset. In accounting, goodwill is defined as the difference between a company’s market value (what people are willing to pay) and the value of its net assets (assets minus liabilities). 

  • Entry cost

How much would it cost to set up a similar business to the one being valued? That’s essentially what the entry cost approach entails. You’ll need to factor in all the elements that it took to set up the current business, from the cost of employees and developing products to building assets and creating a customer base.

  • Industry rules of thumb

Specific industries will have their own specific formula which you can use to value a business operating within that sector. This is a great way for a buyer to value the business based on how they’re expected to operate to industry standard.

These rules of thumb tend to be based on things other than profit. For example, retail businesses will be valued on factors such as business turnover, how many customers it has and its number of outlets.

Share options for business

  • Valuing what can’t be measured

Of course, there are valuable things about a business that can’t be tangibly measured. A business is truly worth what someone is willing to pay for it, so intangible assets have to be considered at times.

A business with a strong relationship with its customers or suppliers may be more valuable to a buyer, while a buyer that lacks a stable team might look at the prospective management and find them a suitable fit. Conversely, buyers can also see risks and the value lowers accordingly; as a business owner, it’s important to pre-empt and minimise potential red flags.


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Other factors that affect valuation:

There are many other additional variables that can affect the value of a business. As a baseline - brand reputation, competitors and the wider economy can play a part, but the following can have more of a major effect:

  • The circumstances surrounding the valuation – take for instance, a voluntary sale against a forced sale.
  • How long the business has been in operation – compare an established company’s profit versus an emerging company’s negative asset value.
  • Business location – a successful business in an undesirable location might decrease the value while a great location is very attractive to business buyers.

Business owners discuss sales options

  • The product or service the business sells.
  • Its earnings history – an increase in gross income over the years will have a positive effect, and vice versa.
  • Future growth potential – business buyers want to know how much they can grow the business.
  • Dependence on the owner – for small business, the owners tend not to stay with the business after a sale. The less dependent the business is on the owner, it stands a greater chance of having a higher business evaluation.

How much is your business worth?

If you’re looking to sell your business, or are keen for an accurate valuation – you’ll be keen to find the truest way to determine its worth.

There’s no one-size-fits-all approach to securing a good valuation, but there are lots of things you can do to improve your chances. Valuing a business can help you focus on areas for improvement later down the line when the time is right for you to sell.

Planning ahead by having a solid business plan, with a focus on the ways you’ll achieve both short-term and long-term results, can stand you in good stead. As we mentioned earlier, reducing risk can also help. Consider whether you rely on a particular group of customers, then diversifying into other areas can help you navigate choppy business waters if a particular customer or client stops doing business with you. The less dependent a business is on a big client, the higher your business valuation will be.   

Additionally, strengthening the accounts and operations processes you have in place is well worth doing, too. Whether it’s financial records or how the business works, take into consideration how you store information. The transparency with which you can show figures and information to buyers may instil greater confidence in them.

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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