When it comes to buying or selling a business, the most important question you need to ask is – how much is it worth?
There is no single formula that can be used to precisely value every private business. The seller will want to drive the price up, and potential buyers will want the opposite.
Although there are relatively easy ways to value certain parts of the business – such as stock, fixed assets (land, machinery, equipment etc.), there will very probably be a sizeable intangible element to the value of a business.
Intangible elements would include “goodwill” – this could include trademarks, and the reputation of the company. Such assets are notoriously difficult to value, and in many cases will come down to how keen a potential buyer is to acquire the business in question.
When looking at the overall value of a business, there are a number of different valuation methods that are commonly used – from using earnings multiples, to calculating how much it would cost to create a similar business.
In this guide, we look at some of the most commonly used valuation techniques, and how other factors may influence the value of a business at any given time.
COMMON BUSINESS VALUATION METHODS
Quite often, multiples of earnings are used as a business valuation method. This method would be suitable for companies with an established financial history.
The Price/Earnings (P/E) Ratio represents the value of the business divided by its post tax profits.
For example, if your company was making post-tax profits of £100,000 and you were offered £500,000 for it, that would equate to a P/E ratio of 5 (£500,000/£100,000).
That equation is simple enough to calculate, however there is no standard P/E ratio figure that can be used to value every business.
Companies within certain industries, such as high tech and IT, will typically command a much higher P/E ratio than more common bricks and mortar businesses such as an estate agency.
Businesses where profits are growing rapidly will also command a higher earnings multiple, than firms where profit growth is low.
The P/E Ratios used in the financial press should be reduced significantly when valuing a small business.
Because a small business can be very reliant on just one main product, or a handful of key executives, buying one is much more risky than purchasing a FTSE-100 giant.
With a small business, the market for the main product could disappear overnight, or the key executives might suddenly decide to leave. If either of these scenarios were to occur, and these things certainly do happen, company profits would tumble and the very existence of the business could be called into question.
A large company with hundreds of different products and thousands of employees, would be inconvenienced by losing a key product or a few important employees, but profits wouldn’t be significantly damaged.
The higher risk of buying a small business is therefore reflected in a lower P/E ratio.
As a very general guide, business advisers may suggest a valuation of between 4 and 10 times the annual post-tax profit.
Quite simply, this is the predicted cost to set up a similar business to that being sold. This would include the cost of developing a customer base and reputation, recruiting and training staff, purchasing assets and developing products and services.
This method is more appropriate for established companies with a high level of tangible assets, such as property companies. The valuation is made by calculating the net realisable value of all assets.
This method uses an estimate of the company’s cashflow over a certain period of time. The “terminal value” of the company is also calculated after this period has expired. The value of the predicted cashflow, plus terminal value, is then discounted, to provide a current business valuation.
It may be hard to establish an accurate terminal value, as it relies so heavily on the cashflow estimates. This valuation method may be used when a company has a lot of potential, but few assets and little financial history to speak of – for example, an online business.
In certain industries, when businesses change hands on a regular basis, industry-wide rules of thumb are sometimes used to value a company. Examples of such industries include recruitment agencies and accountancy practices.
When calculating the value of a business, one or more of these valuation methods may be used. There are also a large number of other factors which may be taken into account – several of which are intangible.
Clearly, a buyer may be more cautious when buying a business during an economic downturn.
On the other hand, when times are good more companies tend to want to grow by buying other firms, and the finance for them to do so is more freely available. With more potential buyers in the market, you are more likely to get a higher price when the economy is booming.
Quite often, such assets can be valued by using the original purchase price and using a depreciation calculation on each item.
Things aren’t always that simple however, as some assets such as property may have risen in value since the original purchase. While, on the other hand, even after a deduction to allow for depreciation, many business assets such as vehicles and specialist equipment may be worth a lot less if you tried to sell them right away.
Some of the most valuable parts of a business may not appear on any balance sheet – these may include trademarks, reputation, branding, key people and the size and quality of the customer base.
Reason for sale
If a sale is forced, any valuation methods are bound to be discounted to encourage a quick sale.
It may be a cliché, but a business is only worth what someone is willing to pay for it. Many small business owners grow attached to their businesses, and often value their companies at higher levels than industry conventions would dictate.
If you are seriously considering selling your business, it is worth being realistic about its true value before offering it up for sale.
And, most of all, make sure you ask your accountant to help you come to a realistic valuation – or to answer any questions you may have when dealing with a potential buyer for your business.