Valuing a business is a complex process, there are many factors that can affect the price such as sector, location, consumer trends and even the current economic situation. Despite all that it’s still worth remembering that a business is only worth what people are willing to pay for it!
There are several reasons why a business will be valued. The first is to assist the selling or buying process, it also can be used to aid the purchase and sale of shares in a business at a price that is fair. A valuation can also help to incentivise management, increase performance or assist in getting investment or finance. With this in mind, what are the main valuation methods?
The Valuation Methods
This is used to value those businesses that are established, stable and have tangible assets that potentially have a large net value.
This would likely include businesses like property and manufacturing companies. The value is derived from the net asset value of the business and then the value of all perceived net realisable value of all assets held by the company.
Any land and buildings would also have to be valued as well as any tooling, plant and equipment.
Earnings Multiple Valuations Using an Established Price to Earnings Ratio
This method is commonly used to value businesses that are either smaller in size or are in a sector that doesn’t usually have a lot of assets. A marketing or recruitment agency for example may only have a few assets like a website. Compared to say a bottling plant which would likely have a lot of assets.
In its basic form, this method involves taking the value of the business and dividing that by its post-tax profits.
Price to earnings ratio is a rule of thumb, but in reality, many other factors go into the valuation.
Certain business types attract high earnings multiples, whilst others are low.
Sector, longevity, growth opportunity all play a part in how many multiples of earnings a business may be valued at.
Discounted Cash Flow
This is a method that is not only complex but is also dependent on the long term business conditions. It is predominantly used on businesses that generate cash, are stable and are considered to be middle-aged.
It takes an estimate of the cash flow of the business over a determined period of time such as 5 or 10 years. This projected cash flow, as well as the terminal value, is then discounted to create a current business valuation.
This is an interesting one and often forgotten metric.
Using this valuation method involves identifying the cost of setting up a business that is similar in nature.
For some businesses, it’s not quite as simple as throwing money and manpower at a problem… It takes time and long formed relationships to get to where they are.
Valuing a business based on entry cost involves understanding the cost involved in raising the required finance as well as buying fixed assets and working capital. The process will also consider the development of new products, recruitment and training as well as increasing customer numbers.
A big barrier to entry is one reason why businesses are brought. Rather than attempt to start from scratch many companies would prefer to acquire another company already in the position they want to be in.
Additional things like being on an approved contractor list with the government or other desirable client can also be very attractive to a potential buyer and increase the valuation. Easier to buy your way onto a list than spend years getting approval!
Industry Sector Rule of Thumb
In many industries, the purchase and sale of businesses is common practice. In some industries, businesses are sold so frequently that this has created the development of industry-wide rule of thumb.
These are reliant on a range of factors such as sales revenues, the volume of customers, location, client demographic and more.
So a business can then be effectively valued using the rule of thumb multiples that are specific to that sector.
It’s crucial to remember that no two businesses are created equal. A business in one sector might be worth many times more than a similarly profitable business in another.
Some sectors are super ‘hot’ and attract a lot of demand pushing up the price. Others are less desirable and only really attract a very specific type of buyer.
An example might be a digital product website with remote staff vs a roofing company.
The website could be owned and run from anywhere in the world, the staff are remote and potential to grow using the existing customer base or expand into new areas is likely.
The roofing company may well be generating more profit but is restricted geographically and is somewhat capped in terms of earnings. Anyone managing the business might need to be skilled at roofing in order to quote effectively.
These are perhaps two extreme examples but you can see that two businesses that might look the same on paper financially can have very different valuations!
Valuing a business is a mixture of art and science. When looking for help with a business valuation it’s important to make sure the valuer has experienced and understands the sector thoroughly to maximise an accurate valuation.