How to value a business

Your accountant may be able to help you value your business, but a business broker (or business transfer agent in the UK) or corporate financier is best qualified to help anyone selling a business.

It’s difficult to say definitively whether business valuation is an art or a science. On the one hand several experienced brokers could give a wide range of values for the same business; on the other, there are recognised valuation formulae to follow.

David Rhodes, a broker for the UK-based Horizon Business Agents, says: "I'd say it's a simple thing to value a business – there are well known criteria.

“I tell the client what I think the market will bear. There have been times where a buyer pays more than I advised the client it was worth, but 95% of the time I'm about right.”

Don Glossop, managing director of Andon Frères, suggests the process is more complex: "The valuation of companies is not a precise science, it's a complex process based on an array of different information that can be subject to change.”

The valuation of companies is not a precise science, it's a complex process based on an array of different information that can be subject to change

Don Glossop, Andon Frères

However, Andon Frères operates at the mid-market level – meaning medium-sized companies with revenues in the hundreds of thousands or millions of pounds. A process by which a multimillion pound manufacturing business is valued would naturally be more complex than the process of valuing lifestyle businesses like newsagents or hair salons.

A business’s value is derived from ‘tangible’ and ‘intangible’ factors and the former are much easier to measure than the latter.

"All companies are different,” says Glossop. “Their valuations are subjective and there are many factors that can affect a company's value. These include tangible factors such as profitability – historic, current and forecast – the extent of contracted income or recurring revenues, the strength of the balance sheet – net asset value – etc.”

Tangible factors, which are comparatively easy to quantify because they are valued according to financial ratios or market rates, can include:

• Financials: history of profit, revenue and cashflow
• Premises
• Stock
• Equipment
• Vehicles
• Fixtures and fittings

Intangible factors are more difficult to evaluate because ascribing a value is more of a subjective judgement.

They can include:

• The business’s reputation and longevity
• Relationships with suppliers
• Goodwill – ie, your reputation among customers and potential customers
• Quality of products and services
• The value of licences
• Patents of intellectual property
• Quality of your employees
• Level and quality of competition (and potential for new market entrants)
• Volume of repeat business
• Potential threats – eg, regulatory changes on horizon – or opportunities – eg, a government house-building programme might boost a construction business

You can value a tangible factor such as premises by comparing it to buildings of a similar size and condition in the same area. Quantifying a company’s reputation and ascribing to it a financial value poses a much bigger headache.

Common business valuation methods

Multiple of earnings

Businesses can be valued according to a multiple of the business’s profits. The broker will recommend a price/earnings (P/E) ratio, usually between five and 10 times the annual post-tax profit, depending on the nature of the business.

A technology business, for example, has much greater growth prospects than, say, an estate agency, and therefore will probably be valued according to a much higher multiple. Ratios for small businesses tend to be lower than for large companies as the barriers to acquisition are more significant.

The income a business will generate is the ultimate determiner of value and obviously current profitability is an effective guide to this. The P/E ratio is also easy to use and understand.

However, recent profits can be misleading. Profits might be high partly because essential capital investment has been delayed, for example, or the entrance of a nearby competitor could threaten to erode market share and income.

Entry cost

The entry cost method seeks to establish how much it would cost to set the business up from scratch, including buying premises, training staff, buying stock, developing products and services, spending on marketing to spread brand awareness and build reputation, and establishing a customer base.

This is obviously a useful, fair method insofar as you’re clearly monetising the individual components of the business. However, a business is more than the sum of its parts and in theory the vendor is only being paid for the money they’ve invested in the business, not the effort and time nor, more crucially, for the growth potential you have fostered.

Asset valuation

Asset valuation is the total value of the business’s assets minus the total value of its liabilities. This valuation method is particularly suitable for businesses with a large number of tangible assets, for example estate agents.

However, the valuation would be misleading if, for example, if an estate agent had been getting a lot of bad press about being unreliable and unscrupulous. So they may have £10m worth of property on their books, but they could struggle to attract buyers because of their sullied brand image.

Assessments of the value of fixed assets should incorporate a depreciation calculation into the formula. And you cannot just assume that property retains the same value from when you bought it because of market fluctuations.

Discounted cashflow

Deriving the value from the company’s projected cashflow over a number of years, discounted cashflow is ideal for a company with considerable potential and which has invested heavily but has few assets and little financial history. New internet businesses, for example, are often valued using this kind of valuation.

The sum of future cash flows, called the net present value (NPV), is discounted to take account of the time value of money (the principle that the buyer should be compensated for having to wait to realise their cash) and a risk premium to insure against the chance that the cashflows never materialise.

Industry valuations

Some industries have their own unique valuation methods, usually called rule-of-thumb valuations. Writing on CanadaOne.com, professional valuator Andre Pontoni described rule-of-thumb valuations as “an average of prices from a number of transactions converted to a multiple linked to a common element found in all companies in a particular industry.”

He goes on to explain the pitfalls: “Each company has a different history and future and therefore specific adjustments are required to normalize a Company's earnings. Applying a rule of thumb or multiple blindly to a Company's earnings without consideration for these adjustments will either overstate or understate value.”

Circumstances of buying and selling parties

The seller’s circumstances can have a bearing on the valuation. For instance, if they’re in a rush to sell then they may lower the value to speed up the process of finding a buyer.

“The buyer's circumstances might also affect potential value,” says Don Glossop, who identifies three types of buyer:

• Individuals who have to borrow money (“in which case servicing the debt has to be factored into their calculations of value”)
• Corporate buyers, possibly in an adjacent, complementary sector, looking for diversification (“might be prepared to pay a premium”)
• Competitors (“who can see synergies and potential economies of scale, therefore may be prepared to pay a premium”)

For most lifestyle-type businesses, like cafes, convenience stores or post offices, the vast majority of buyers will be individuals like themselves who have to borrow money.

Find out about the pitfalls of business sales