How To Value Your Business

It’s often said that a business is only worth what someone is willing to pay for it, but there are several methods you can use to reach a sensible valuation figure.  Valuing a business isn’t only useful for business owners and entrepreneurs looking to buy or sell a company.  A company valuation can help when:

• Securing investment – think of Dragons’ Den, where investors want to see a realistic figure and value in the deal you give them;
• Setting a fair price for employees – if your employees want to own a stake in the company;
• Growing or expanding your business – an annual valuation helps to keep the score on how well you are doing.

Ultimately, you want to reach a valuation that doesn’t sell the business short. It also shouldn’t overstate what the business is actually worth.  It’s tricky to find a balance, so it’s a good idea to combine a couple of valuation techniques.

What affects a business’s value?

While there are some parts of a business you can value easily, there are always going to be areas that are less easy to value, i.e. intangible assets.  Beyond stock and fixed assets (like land and machinery), which are tangible and have clear value, you should also consider:

• the business’s reputation;
• the value of the business’s customers;
• any patents and trademarks;
• the circumstances surrounding the valuation (like a forced sale rather than a voluntary one);
• the age of the business (think start-ups making a loss that have lots of future potential, versus established profit-making companies);
• the strength of the team behind the business;
• what kind of product you have.

These intangible assets make it fairly difficult to reach an accurate overall valuation.  However, there are a number of techniques you can use to make the process easier.  These are explained below.

Business valuation methods

1. Price to earnings ratio (P/E or multiple)

Businesses are often valued by their price to earnings ratio (P/E), or multiples of annual profit. This number is a speculation on the business’s ability to generate profit into the future.  If it has a strong track record of consistent profits, then the multiple will be higher than one with erratic or non-sustainable profits.  However, a business with low profits can have a high multiple if it has great prospects for growth. (Think Amazon and Uber in their early days.)  You can see quoted companies’ historic P/E ratios in the financial section of the papers.  As their shares are easier to buy and sell, they’re more attractive to investors so they get a higher value.

The P/E ratio for SME’s are must harder to calculate, and are normally based on factors such as those referred to above.  As a guide. the average P/E ratio for SME’s sold is 2.7, while the average for a traded PLC is about 15, so you can see what a difference it can make.  As an example, using a P/E ratio of 3 for a business that makes £500,000 annual post-tax profits gives a value of £1.5m.  In comparison, a listed company with a P/E ratio of 15 would be worth £7.5m.

The key to getting a higher multiple is to have a business that works without being reliant on any one factor, such as a customer, supplier, team member or, most importantly, the business owner.  The buyer is paying for the ability of the business to generate profits into the future, and if there are any factors that could impact on that, such as the risk of losing a major customer, the multiple will be reduced dramatically.

2. Entry cost

This method is good for businesses that have invested heavily in getting started but have not yet made profits.  Here the earnings multiple is invalid, as any multiple of zero is zero!  It is generally more mature businesses that will acquire such businesses, because it helps them move into new market places, and bring new products to market quicker than doing it themselves. The more time and money you can save them getting to market, the more they will be willing to pay you. for your business.

In order to value the business, you would need to estimate how much it would cost and how long would it take to set up a similar business, factoring in everything that got your business to where it is today.  This would require you to calculate all the start-up costs, costs of brand building, costs of product development, marketing expenditure to build up a customer base, staff recruitment and training, etc.

3. Asset based valuation

Stable, established businesses with a lot of tangible assets are often suited to being valued based on the value of their assets. Good examples of businesses like this are those in property and manufacturing.  To carry out an asset valuation, you need to start with the Net Book Value (NBV) of the company’s assets. This is the value of the assets as recorded in the company’s accounts.  Then, you need to consider the economic reality surrounding the assets.  Essentially, this means adjusting the figures according to what the assets are actually worth.  For instance, old stock depreciates in value.  If there are debts that aren’t likely to be paid, the value of these should be deducted.  And property could have changed in value, so review those figures, too in arriving at your overall valuation.  Don’t forget there may also be intangible asset values to add, such as goodwill etc.

3. Discounted cashflow

This is a complex way of valuing a business, relying on assumptions about its future cashflows.  The technique is suited to mature businesses with stable, predictable future cashflows – such as utilities companies.  The discounted cash flow method of valuation works by estimating what future cashflow would be worth today.  You reach a valuation by adding the dividends forecast for the next 15 or so years, plus a residual value at the end of the period.

Today’s value of the future cashflow is calculated using a discount rate, which accounts for the risk attached, and time value of money.  The time value of money is based on the idea that £1 today is worth more than £1 tomorrow, because of its earning potential. Normally, the discount interest rate can be anything from 15 to 25 per cent.

4. Industry “rule of thumb”

Buying and selling businesses can be more common in particular industries, so those industries might have certain rules of thumb that you can use as a guide. These will be based on factors other than just profit.  For example, retail businesses can be valued on factors like business turnover, how many customers it has, and its number of outlets.  Accountancy firms are valued based on an average of the last three years’ fee income.

If you want more than the industry standard suggests your business is worth, then you will need to show how you are better than than average in your industry.

5. Valuation based on what can’t be measured

This brings us round to what we said at the beginning – a business is worth what someone is willing to pay for it.  The value of intangible assets, as mentioned earlier, could be considered here. Your negotiation skills will also play a part, too.  If the business has desirable relationships with customers or suppliers, it might be more valuable to a buyer.  If the buyer doesn’t have a stable team behind them to take the business forward, a strong management team (that won’t jump ship) could also add value.  And each prospective buyer might see different risks, variably lowering the value. The key as a business owner looking to sell for the best price is to pre-empt any minimise any perceived risks.

How Much is YOUR Business Worth? 

Valuing your business can be very useful as a way of helping you focus on areas that need improvement.  Before you need to sell your business, there are a lot of things you can do to help secure a good valuation, including:

• Planning ahead. Have a solid business plan in place, with a focus on how you’re going to achieve both short-term and long-term goals and results;
• Reducing risk.  For example, if you rely on a particular customer/group of customers or product, consider diversifying.  Build a great team who will be an asset to the buyer;
• Improving your processes. Think about the systems you use, and how you store information, whether it’s financial records, stock control or simply how the business works.  Often, the more you can demonstrate that you have a handle on the business, the higher the buyer’s confidence in you;
• Considering potential buyers. Thinking about the type of person who will buy your business is important, as different people will have different motivators,. The more valuable you can make your business to them, the more they will be willing to pay you for it.

A valuation method that works for one business won’t always work for another.  By giving an overview of several popular business valuation methods, though, we hope you’re closer to coming up with a range of figures that will help you to understand the value of your business.

If you are thinking of selling your business in the next few years and you want to maximise its value, please get in touch.  We are always willing to provide a simple calculation for you to give you an idea of your business’s current value, and areas you could look at to increase that value.