Perhaps you have spent the last few years working hard to build your business and are now looking to sell it to relax and spend some quality time with the family. Alternatively you might be looking to attract some investment to support an expansion, acquisition or diversification. Whatever the reason you will need to determine the present and projected future values for your business.
Historically the calculation was a fairy straightforward one based on turnover, costs and projected growth but today there are a number of ways to come to a value. Regardless of the mechanism adopted it still holds broadly true that any business is worth is precisely what someone is willing to pay for it!
This article is not intended to provide an exhaustive description of the various methods available but instead to provide a very broad overview. We strongly recommend that, if you about to look to sell, or take on investment, that you take expert and independent guidance.
Business valuation approaches
Broadly speaking there are three approaches to valuing a business and each can be used as the basis for a more focused model that is closely aligned to the nature of your business, the market you operate in and any existing best, or accepted, practices:
This works on the principle that each business is comprised of a number of assets and liabilities. It estimates the cost to create a similar business with comparable benefits by determining the value of the assets minus any liabilities.
It’s a relatively simple approach but it does depend on a realistic assessment of which assets and liabilities need to be included and their relative value. This approach is best suited to a relatively simple retail type business.
This is a model based on multiples of earnings using a Price/Earnings (PE) ratios which are factored to calibrate valuation projections based on similar businesses.
There is no standard P/E ratio figure that can be used to value every business and companies in certain industries, such as high tech and IT, will have a much higher P/E ratio than more traditional businesses such as a retail business. P/E ratios also need to take into account company size as small businesses can be more reliant on a small number of key clients or few products and services that a much larger business.
The formula for calculating P/E is simple: The market value per share divided by the earnings per share. Market value per share is how much it costs to buy a share of any publicly traded company on the stock Market. Earnings per share is calculated by taking a company’s net income over the last four quarters, subtracting any dividends, and then dividing the rest by the number of shares outstanding.
P/E by itself is useless; the number doesn’t tell you anything unless you compare it to other companies’ P/E’s in the same industry. Companies with lower P/Es’ are considered “cheaper” to buy — for how much they earn, their stock price is cheaper — although this analysis alone won’t tell you whether to buy a company.
Although P/E is often thought of as an indication of how the company has been priced in the past, it’s also an indication of what investors think of its future. That’s because stock prices are a reflection of how people think a stock will perform in the future. Therefore, companies with high P/Es’ are a sign that investors expect higher earnings growth in the future.
Taking on a bunch of debt generally increases a company’s risk profile. That being said, of two companies with the exact same operations, trading in the same sector, the company with a moderate debt load with have a lower P/E ratio than the company with no debt.
This is the type of model that probably applies to most IT start-ups with few tangible assets and liabilities and also helps to explain the staggeringly high valuations that some businesses attract. It’s also not unusual to see companies ‘tacking’ to align more closely to market sectors that attract higher investor valuations.
The risk of this model is that you need to closely watch the market for any change in direction that may impact your valuation. How many IT managed services businesses embraced cloud services a few years back to find themselves in a market where margins are thinning as the larger providers engage in a ‘race to zero’ and those P/E ratios are adjusted downward!
The last approach works on the basis that a business is there to generate a profit and that based on investment it will generate a return that can be forward projected. This projected income also needs to be calibrated by a risk factor.
The way to calculate the present value is either by ‘Capitalization’ or by ‘Discounting’. Capitalization rates provide a multiplier for the annual earnings to determine the business value. By way of example a Capitalization rate of 25% indicates that the company is worth 4x its annual turnover. Discounting uses projected revenue over a period of time multiplied by a discount rate that factors in the risk of not achieving that level of turnover. The residual or terminal value is a forward projection of company value.
A business with steady growth best suits the capitalization method. A business with less predictable income best suits a discounted approach.
There are also a large number of other factors which need to be considered as part of any company valuation:
- Economic: Investors and buyers will be more cautious during an economic downturn. When markets are in growth more companies tend to want to grow by buying other firms, and the finance to support this is more freely available.
- Assets: Some assets can increase in value (e.g. property) and some may depreciate (e.g. any tech) outside of accepted levels.
- Intangible: Some of the most valuable parts of a business may not appear on the balance sheet such as IPR, branding, key people and the clients.
- Reason: If a sale is forced, any valuation methods are bound to be discounted to encourage a quick sale.
- Market: As we started this article, a business is only worth what someone is willing to pay for it. Find the right people at the right time and the valuation can be much higher than predicted.
This article provides a brief overview of the approaches used to value a business. It is a hugely complex topic, particularly if you are in a fast moving, or a new market, with significant levels of innovation. We strongly urge you to see independent and expert guidance to help you maximize both value and the likelihood of a sale or investment!