Understanding how much a business is worth - and how it can be made more valuable - is of vital importance to anyone buying, selling or simply running a business.
Business valuation hinges upon how much profit a buyer can make, balanced against the risks involved. Past profitability and asset values are only starting points. Intangible factors, such as customer goodwill and intellectual property, often provide the most value.
1. Why value the business?
There are four main reasons for valuing a business.
To help you buy or sell a business
Understanding the valuation process can help you to:
- improve its real or perceived value
- choose a good time to buy a business or sell your business
- negotiate better terms
- complete a purchase more quickly
There is a better chance of a sale being completed if both buyer and seller start with realistic expectations.
To raise equity capital
- A valuation can help you agree a price for the new shares being issued.
To create an internal market for shares
- For example, so that employees can buy and sell shares in the business at a fair price.
To motivate management
Regular valuation is a good discipline. It can:
- measure and incentivise management performance
- focus management on important issues
- expose areas of the business which need to be improved
2. Basic business valuation criteria
Three basic criteria affect valuation.
The circumstances of the valuation
- An ongoing business can be valued in several different ways (see Business valuation techniques).
- A forced sale will drive down the value. For example, an owner-manager who needs to retire due to ill health may have to accept the first offer that comes along.
- If you are winding up the business, its value will be the sum of its realisable assets, less liabilities (see Asset valuation).
How tangible the business assets are
- A business that owns property or machinery has tangible assets.
- Many businesses have almost no tangible assets beyond office equipment. The main thing you are valuing is future profitability.
How mature or stable the business is
- Many businesses make a loss in their first few years.
- A young business may have a negative net asset value, yet may be highly valuable in terms of future profitability.
3. Business valuation techniques
It is important to remember that the true value of a business is what someone will pay for it. To arrive at this figure, buyers use various valuation methods. You usually use at least two methods to arrive at a range of values.
- Asset valuation can be appropriate if your business has significant tangible assets. For example, a property business.
- The price earnings ratio can be used to value a business that is making sustainable profits.
- Entry cost valuation values a business by reference to the cost of starting up a similar business from scratch.
- A discounted cash flow valuation is based on future cash flow. This method is appropriate for businesses that have invested heavily and are forecasting steady cash flow over many years.
- Industry valuation rules of thumb use an established, standard formula for the particular sector.
4. Asset valuation
Add up your assets, take away your liabilities, and you have the asset valuation. This method does not take account of future earnings.
Use asset valuation if you have a stable, asset-rich business
- Property or manufacturing businesses are good examples.
The starting point for an asset valuation is the assets that are stated in the accounts
- This is known as the Net Book Value (NBV) of the business.
You then refine the NBV figures for the major items, to reflect economic reality
- property or other fixed assets which have changed in value
- old stock which would have to be sold at a discount
- business debts that are clearly not going to be paid (bad debts)
- over-conservative existing provisions for bad debts
- intangible items, such as software development costs, should usually be excluded
Consider the future status of the business
If a business is going to cease trading, it will lose value due to:
- Assets being sold off cheaply. For example, equipment sold off at auction may only achieve a fraction of its book value.
- Debt collection is likely to be more difficult.
- The cost of closing down premises.
- Redundancy payments, if applicable.
5. Price earnings ratio
The price earnings ratio (P/E ratio) is the value of a business divided by its profits after tax. You can value a business by multiplying its profits by an appropriate P/E ratio (see below). For example, using a P/E ratio of five for a business with post-tax profits of £100,000 gives a valuation of £500,000.
P/E ratios are used to value businesses with an established, profitable history
- P/E ratios vary widely.
Compare your business with others
- What are your quoted competitors' P/E ratios? The financial pages of the newspapers give historic P/E ratios for quoted companies.
- What price have similar businesses achieved?
Quoted companies have a higher P/E ratio
- The shares in quoted companies are much easier to buy and sell. This makes them more attractive to investors than shares in comparable unquoted businesses.
- Most P/E ratios for quoted companies vary between ten and 25, though there are exceptions.
- Typically, the P/E ratio of a small unquoted company is 50% lower than that of a comparable quoted company in the same sector. Typical P/E ratios for unquoted companies are between five and ten times annual post-tax profits.
P/E ratios are affected by commercial conditions
- Higher forecast profit growth means a higher P/E ratio.
- Businesses with repeat earnings are safer investments, so they are generally awarded higher P/E ratios.
Adjust the post-tax profit figure to give a true sustainable picture
How to calculate profit
If you are considering buying a business, work out what the true profitability is.
Compare the owner's stated profits with the audited figures
- Question any differences.
Look for costs that could be reduced under your ownership
- consultancy fees
- payments to the owner and to other shareholders
- unnecessary property leases
- cheaper alternative suppliers
- excessive overheads
Check how the accounts have been worked out
- If necessary, restate the accounts using your own accounting policies. This will often result in a significantly different profit figure.
- For example, money spent on software development might have been capitalised by the owner. You might consider that it should have been treated as a cost.
When looking at future profits, bear in mind the costs of achieving them
These may include:
- servicing increased borrowings
- depreciation of investment in plant, machinery, or new technology
- redundancy payments
The arrival of new management often leads to major changes that may mean higher costs and lower productivity in the first year.
6. Entry cost valuation
Rather than buy a business, you could start a similar venture from scratch. An entry cost valuation reflects what this would cost.
Start by assessing the main costs
Calculate the costs to the business of:
- raising the necessary finance
- purchasing the assets
- developing its products
- recruiting and training the employees
- building up a customer base
Factor in any cost savings you could make
For example, by:
- using better technology
- locating in a less expensive area
The entry cost valuation can then be based on cheaper alternatives, which is more realistic.
7. Discounted cash flow
This method is the most technical way of valuing a business. It depends heavily on assumptions about long-term business conditions.
Discounted cash flow valuation is used for cash-generating businesses that are stable and mature
- A discounted cash flow valuation relies on confidence about the business's long-term prospects.
- For example, a water company with a local monopoly might expect relatively predictable cash flows.
The valuation is based on expected future cash flow
- Cash flow is forecast several years into the future, plus a residual value at the end of the forecasting period.
- The value today of future cash flow is calculated using a discount rate which takes account of the risks and the time value of money. (£1 received today is worth more than £1 received in a year's time.)
8. Industry valuation rules of thumb
In some industry sectors, buying and selling businesses is common. This leads to the development of industry-wide rules of thumb.
Rules of thumb are based on factors other than profit
- turnover for a specific type of business
- the number of customers
- the number of outlets
Buyers work out what the business is worth to them
- Take the example of a IT maintenance business with 10,000 contracts but no profits. A larger competitor might offer £100 per contract to buy the business. This is because it could merge the two businesses, cut costs and increase profits.
9. Intangible elements of business value
The key source of business value may be something that cannot be measured.
Strong relationships with key customers or suppliers may be critical
- For example, if a business holds the UK licence (or UK distributorship) for a product that is expected to be successful, the value of the business will increase accordingly.
Management stability may be crucial, if the purchaser does not have a strong team
If the owner-manager or other key people are going to leave, the business may be worth far less. For example:
- the profitability of an advertising agency may collapse if a key creative person leaves
- if key salespeople leave, they may take important customers with them
Check any restrictive covenants contained in employees' contracts. The covenants could add value if the employees form an integral part of the business. But they could also damage the value if a potential buyer intends to radically change the staffing structure.
The more risks there are from a purchaser's perspective, the lower the value will be
There are specific actions you can take with a view to building a more valuable business:
- Set up excellent management information systems, including management accounts. Good systems make nasty surprises unlikely.
- Tie in key customers and suppliers through contracts and mutual dependence.
- Minimise exposure to exchange rate fluctuations and other external factors.
"Valuing a business is an art form, not necessarily a science." - Brian Hayden, Hayden Associates
"The fortunes, and therefore value, of a small business can deteriorate rapidly. This risk should always be reflected in the valuation of small businesses." - Paddy MccGwire, Silverpeak
"A business's value does not always equal all its assets, but rather the profit and cash flow that those assets can generate." - Brian Hayden, Hayden Associates