There are several methods in which to value a business, but like anything a business is only worth what someone is prepared to pay. A seller will, of course, always try to suggest that a business is worth the highest possible price whereas the buyer will be keen to grab themselves a bargain and consequently suggest that the business is worth less. This guide sets out some of the valuation methods that can be used to value a business and when they may be appropriate.
Multiple of Earnings Valuations
This is a valuation based on multiples of future earnings and is usually suitable for small unquoted companies with a record of sustainable profits. An average multiple will be between five and ten times the business’ annual post tax profit but this may vary and there will always be exceptions to the general rule. Before multiplying the profits any unusual one off items should be discounted.
Discounted cashflow valuations
This is a valuation based on future cash flow. This is more suitable for more mature, cash generating businesses. The method involves making assumptions regarding long term business conditions. The valuation is based on the sum of the dividends that the company predicts will be paid over a long period of time (usually at least 15 years), plus a residual value at the end of the chosen period. The value of all of the future dividends used in the calculation will be calculated in a certain way to take into account the risk and time value of money.
This is a valuation based on the value of the assets owned by the business. This is suitable where a business holds substantial tangible assets. This method of valuation essentially involves adding up the assets of a business and then deducting the liabilities leaving an approximate valuation.
The starting point for the asset valuation is the assets as set out in the accounts of the business, however, these may need to be amended to reflect certain changes e.g. the fact that some assets may have changed in value, the fact that stock may be old and therefore only saleable at a discount, or that there may be bad debts which have not been properly provided for in the accounts.
Entry Cost Valuation
This is a valuation based on the cost of creating a similar business to the one being valued. The valuation would include the cost to the business of purchasing any assets that it holds, the cost to the business of developing its products, the cost of recruiting and providing the necessary training to any employees, and the cost of building up a customer base. From the aggregate costs any costs savings that may have been possible e.g. by relocation or an improvement in technology are deducted.
Price/Earnings Ratio Valuation
This is a valuation based on the value of a business divided by its profits after tax. This is suitable where the business has an established profitable history. It compares the price of a share to the earnings per share. Price/Earning ratios for quoted companies will be higher as their shares are easier to buy and sell. It is useful to compare the Price/Earnings ratio of one business with other businesses in the same industry, this is easier with quoted companies where the relevant details may be shown in the financial press.
Industry Rules of Thumb
In certain industries buying and selling businesses is common place and this has led to certain industry wide rules of thumb. Examples include the number of customers that a mobile phone airtime provider has, or the number of branches that an estate agency has.
Intangible Assets and other considerations
As well as these standard valuation methods there are likely to be a number of intangible assets which may affect the value of any business. These include the business’ reputation and any goodwill that has been built up, the business’ relationship with suppliers, the value of any licenses that the business holds, the value of any patents or other intellectual property rights that the business holds, and the business’ growth potential.
In addition to assets there may be other factors which may have a positive or negative effect on the value and may be the most important issues to a potential buyer. These factors may or may not have been taken into account already depending on the valuation method used. The factors include location, assets, debtors, creditors, suppliers, experience and commitment of key employees, premises, competition, what other businesses in a similar area and industry have been sold for, any other similar businesses that are also for sale in the same area, the economic climate, level of demand in the area, economies of scale (if a potential buyer owns a business in the same or a similar industry), any specific risks, and the circumstances of the sale e.g. if it is a forced sale by reason of retirement or ill health the value may be reduced.
It will be useful to consider how a potential buyer may value your business in preparing your business for sale and deciding on the best time to market it. It is likely that you will use a mixture of the valuation methods set out in order to reach a valuation of your business. It is also imperative that you seek advice from your accountant (whether you are planning on selling or buying a business) to ensure that any valuation exercise is properly undertaken and any necessary financial due diligence is carried out. A business broker or specialist corporate finance accountant may also be consulted in this regard.
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