How to value a business

There are four generally accepted ways of valueing a buisness, these are detailed below with the other main points that should be considered.

EARNINGS MULTIPLES

Quite often, multiple 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. It may not be easy deciding what P/E ratio to use (some industries, such as high tech / IT ones will have a much higher P/E ratio than, say, an estate agency). The P/E Ratios used in the financial press should be reduced significantly when valuing a small business, as the barriers to acquiring a small company are much higher than buying quoted shares on the stock market. Quite often, business advisers will suggest a valuation of between 5 and 10 times the annual post-tax profit.

ENTRY COST

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.

ASSET VALUATION

This method is more appropriate for established companies with a large amount of tangible assets (such as property companies). The valuation is made by calculating the net realisable value of all assets.

DISCOUNTED CASH FLOW

This method uses an estimate of the company's cash flow 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 cash flow, plus terminal value, is then discounted, to provide a current business valuation. It may be hard to establish this terminal value, as it relies so heavily on the cash flow estimates. This valuation method may be used when a company may have a lot of potential, but few assets and little financial history to speak of - for example, a web business.

INDUSTRY VALUATIONS

In certain industries, when businesses change hand on a regular basis, industry-wide rules of thumb are sometimes used to value a company. Examples of such industries include recruitment agencies, accountancy firms, etc.

Other Considerations

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.

ECONOMIC CLIMATE

Clearly, a buyer may be more cautious when buying a business during an economic downturn.

FIXED ASSETS

Quite often, such assets can be valued by using the original purchase price and using a depreciation calculation on each item. Things aren't quite as simple however, as property prices may have risen or fallen since the original purchase, and even after a deduction to allow for depreciation, many business assets (such as vehicles, and equipment) may be worth a lot less if you tried to sell them right away.

INTANGIBLE ASSETS

Some of the most valuable parts of a business may not appear on any balance sheet - these may include trademarks, reputation, branding, key people, the size and quality of the customer base. Valuing the potential value of a business is notoriously hard to do, but clearly a rapidly growing business will be very attractive to buyers.

REASON FOR SALE

If a sale is forced, any valuation methods are bound to be discounted to encourage a quick sale.

REALITY

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. So, it is worth being realistic about the true value of your company before offering it up for sale.