A Guide to Valuing a Business - Business Valuation Explained.

Valuing a Business - Business Valuation Explained.

Published on: 2010-01-08

Introduction

How much is this business worth? How can I improve its value? These two questions are never far from the minds of business owners or potential business buyers, but surprisingly not too many owners have a clear answer for either.

It’s scary to think that as many as 66% of small to medium sized business owners in the UK have no clear idea of what their business is worth. And a similar number have no clear exit strategy highlighting what they hope to achieve from the sale of their business in the future. It’s by knowing what a business is worth that you can formulate an idea of what you want it to be worth when you decide to sell it. I can only imagine how many people decide to sell their business, retire and live the good life, only to find out that they are not as well off as they thought they were.

If you’re a buyer, then you’re probably more concerned with making sure you don’t pay too much for the business. The value of a business depends on how much profit the potential purchaser can make within a certain period of time and what level of risk is involved, should he/she purchase the business.

What factors influence the value of a business?

Circumstances of sale

Sometimes owners are forced to sell their businesses because of ill health or for some other unforeseeable reason. This could reduce the value of a business severely because the owner is willing to accept a lower price to ensure a speedy sale. On-going businesses however can afford to wait for a better offer.

An exit strategy can help you plan for the unexpected and generally results in a higher price being achieved.

How tangible are its assets?

If a business has a large amount of assets like property or machinery, but a low amount profit, it can still be worth a lot because of the assets underpinning its value.

Other companies have relatively few tangibles assets and are valued based on their profit potential rather than their asset value.

Age

Younger companies tend to represent more risk for buyers and usually sell for less than established businesses. An older business is more settled and likely to be able to turn a consistent profit over a long period of time whereas younger companies tend to be more unpredictable.

Sometimes young companies, despite their instability, can still fetch a good price based on their future earnings potential.

Financial Performance

One of the more obvious factors that influence the valuation of a business, is it's historic financial performance. Poor results leading up to the sale of your business can have a large impact on what buyers are prepared to pay. In many instances the previous years accounts play the biggest part in a business valuation and any exit strategy you formulate must have this as a core consideration.

A strong financial performance will almost always result in a higher value but bare in mind that the potential buyer will want to be satisfied that the same performance can be repeated if the business is bought.

Valuation Techniques

You should always remember that a business is only worth what someone is prepared to pay for it.

Net Profit Multiples (P/E Ratio)

Multiples of a business’s net profit are often used to calculate its value. This method is popular for valuing businesses with a low level of physical assets because it relies more on the businesses earning potential. One way to determine what value your profit margin should be multiplied by is too look at what sort of return an investor can get for his money in the market place. Let’s say you do a quick search on the internet and discover that the maximum amount of guaranteed return available to an investor is 10-15% per year. The selling price must reflect a better return on investment for the buyer than what is available to him in the marketplace. So let’s say you decide that 20% return per year is fair. 20% is one fifth of 100%, so therefore you’d multiply your profit after tax by 5 to reach a fair price. But sometimes your industry is growing very rapidly and the fair rate of return can be reduced to account for increased profit in the future.

[Profit after tax] X (100 / Fair rate of return) = Estimated Value

This method requires net profit and an idea of what represent a fair rate of return within your industry. Typical multiples range from 1 to 10 dependent on expected growth, with 5 being about average for small businesses. It is not unusual for companies within the IT industry to use multiples of 25 because of the high growth potential.

Asset Based Valuation

If the business is asset rich, then an asset based valuation is normally preferred. This method of valuing a business relies on knowing the value of a business’s assets and what its outstanding liabilities are.

Assets – Liabilities = Value (Equity)

Remember that a company’s assets according to its books may not reflect what the assets are really worth, so you may need to make sure of their exact value. The form of valuation is commonly applied to manufacturing or property based companies.

Entry Cost Valuation

This form of business valuation looks at what it would cost to create a similar business in the current market. Valuing a business in this manner is quite complex because there are so many factors to take into account. These could include the cost of employing staff, buying equipment, researching products and securing customers. It’s probably a good idea to seek out a valuation agent with specialist knowledge of your industry if you want to use this method.

Industry Accepted Methods

Some industries have pre determined methods of valuing a business. For instance estate agents can be assign a value based on the number of branches they hold. You should consult a valuation agent or business broker who is experienced in selling similar businesses in your industry if you are not sure.

Which ever method you decide to use remember to be realistic, otherwise you could frighten off potential buyers. There may be no demand for your type of business in the market, and selling off the assets could be worth more than discounting it to ensure a quick sale.

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