How to value a business
Business valuations are crucial for a wide range of companies, from budding start-ups to well-established enterprises.
A business valuation might be necessary under several circumstances such as when you're contemplating selling your business, seeking to raise capital, involved in a merger or acquisition, or engaged in succession planning.
In this guide we’ll outline what a business valuation is, why it’s important to have an accurate one, and eight possible methods you can use to calculate it.
What is a business valuation?
In simple terms, a business valuation determines how much a business is worth in monetary terms.
A valuation will take into account a number of characteristics of the business such as its asset inventory or its cash flow when determining its true value.
A business valuation can be determined by a range of methods and a business valuation will often be reached by combining a blend of these techniques for a more comprehensive view.
These methods can include:
- entry valuation
- discounted cashflow
- asset valuation
- times revenue method
- price to earnings ratio
- comparable analysis
- industry best practice
- precedent transaction method
When looking to undertake a business valuation exercise it’s a good idea to seek independent, specialist advice from a financial services professional with experience in industry.
Why business valuation is important
A business valuation is vital when a business is looking to raise investment or for the process of selling, merging, or purchasing a company.
An accurate valuation provides a transparent and pragmatic view of your business's market worth.
Being aware of your business's value enables you to determine a fair selling price, negotiate efficiently with prospective buyers, and secure beneficial financing deals, among other advantages.
An accurate business valuation also serves as a guideline for the long term financial health of your business and its potential for long-term survival.
It illuminates your company's strengths and weaknesses, thereby enabling you to make more strategic decisions in the future.
It's like a health check-up for your business, giving you insights into its vitality and endurance over time.
Calculating how much your business is worth
Assessing the value of your business goes beyond just presenting a quick glimpse of the profits and losses.
There are a variety of methods used to evaluate the value of a business, each with its own strengths and weaknesses.
Many valuations will incorporate a combination of different methods to arrive at a more comprehensive figure.
1. Entry Valuation
The Entry Valuation Framework is a model that determines the value of a business by calculating the cost of creating a similar venture from scratch.
In simple terms, it answers the question: "How much would it cost to start my business today if it didn't already exist?"
To get a precise estimate, start by itemizing all the potential start-up’s costs.
Once you've compiled this list of expenses, think about areas where you could cut costs if you were starting again.
This could involve using a more innovative approach in order to create efficiency savings for example.
By subtracting these potential savings from your projected start-up costs you will be able to determine the entry valuation cost.
Entry Valuation Cost = Projected Start-up Cost - Potential Savings
It’s worth bearing in mind that this method only provides a snapshot of your business's value at a specific moment.
It doesn't offer insights into the future value of your business.
While this approach can be useful for very new or niche start-ups, businesses with more financial history or competition may benefit from other, more widely accepted valuation methods.
2. Discounted Cash Flow (DCF)
The Discounted Cash Flow (DCF) method is a sophisticated approach to business valuation that focuses on determining the present value of future cash flows.
In essence a DCF business valuation will calculate what a future cash flow stream would be worth today and therefore figure out how much a company might be worth in the future.
This method is typically used by established businesses with stable and predictable cash flows projected for the coming years.
To calculate the present value of future cash flows, you apply a discount interest rate to account for any risk factors, like unforeseen expenses or bills, and the time value of money.
The concept of the time value of money suggests that £1 earned today holds more value than £1 earned tomorrow due to its potential to earn returns.
This valuation technique is commonly employed when seeking investors, such as Venture capitalists and Angel investors, as it helps them predict whether a business can generate a return on their investment within their desired timeframe.
To estimate this, you would examine the projected cash flow over the repayment period and subtract the discount rate.
Ultimately, if the calculated value surpasses the initial investment, then it could be a worthwhile investment to consider.
3. Asset valuation
If your business possesses substantial assets, conducting an asset valuation could provide a comprehensive understanding of your business's overall value.
Assets can be categorized into two types: tangible and intangible.
Tangible assets are physical items owned by your business, such as your office space, inventory, land, and equipment.
Conversely, intangible assets are non-physical properties, including your business's brand, reputation, and intellectual property like copyrights and patents.
The Net Book Value (NBV) of your business is calculated by deducting the costs of your business liabilities, including debt and outstanding credit, from the total value of your tangible and intangible assets.
To maintain accurate asset valuations, it's a good idea to consistently update your asset records, taking into account factors such as inflation, depreciation, and appreciation.
It's worth noting that the asset valuation method often results in the lowest value for a business.
This is because it doesn't consider 'goodwill' - an accounting term referring to the difference between a company's market value (what people are willing to pay for it) and the value of its net assets (the difference between assets and liabilities).
Asset valuation might not be the best way to evaluate a business which has an abundance of intangible assets as it might fail to properly capture the future value of the business and its growth prospects.
4. Times revenue method
The Times revenue method is commonly used when valuing new or early-stage companies that lack sufficient earnings history to utilise other valuation models.
This model calculates the revenue of a business, typically over a year, and multiplies it by an industry-specific multiplier.
The multiplier typically ranges between 0.5 and 2, with lower values used for slower-growing industries and higher values for industries anticipated to grow rapidly.
It's a good idea to consult with an independent financial advisor to determine the appropriate multiplier for your specific industry.
It should be noted though that this isn't the most reliable form of business valuation.
This is because revenue doesn't necessarily translate into profit, and the Times Revenue method doesn’t take into account a company's expenses and its capacity to generate a positive net income.
5. Price to earnings ratio
The Price to Earnings (P/E) ratio valuation method evaluates a company's stock price in relation to the profit an investor can anticipate from it.
This is often calculated using an average of share prices and earnings over the previous twelve months.
Your P/E ratio can then be compared to other businesses within your industry to determine if it falls below, meets, or exceeds the industry average.
A high P/E ratio might suggest that a company's stock price is high relative to its earnings, possibly indicating an overvaluation of the business.
On the other hand, a low P/E ratio implies that the stock price is low compared to its earnings, which may suggest the business is undervalued.
This valuation method is most commonly used by larger businesses that are publicly traded.
However, it's not applicable for smaller, privately-owned businesses as they lack publicly available stock prices.
If your company is privately held, you may want to explore other relevant ratios for your industry, such as the revenue/cost ratio.
It’s worth noting that not all assets and value can be measured by a formula with the value of intangible assets such as the reputation of your business, being particularly difficult to capture.
6. Comparable analysis
The Comparable analysis method is a simple yet effective approach to valuing your business.
It involves estimating the worth of your business by comparing it to similar businesses in your industry.
This method provides an observable value for your business based on the current market value of comparable companies.
To create a comparable analysis business valuation, you would utilise some valuation methods such as the price to earnings ratio or enterprise value/EBITDA.
These tools help you ascertain the value of a comparable company, which you then use as a benchmark to determine your own business's relative valuation.
However, it's important to note that public companies often have higher valuations than private ones due to their marketability and liquidity.
So, if the data you've used is from a publicly traded company, you may need to apply a discount to your valuation if your business is privately held.
This discount can be substantial and usually ranges between 30% to 50%.
It's a good idea to consult an independent financial advisor to determine the appropriate rate for your specific industry and business.
7. Industry best-practice
In certain industries business purchases and mergers happen very frequently, such as in the retail sector.
In these sectors, indicators such as business turnover, customer volume, and number of outlets provide insights into the true value of a business and can be used as a useful reference point for valuing similar businesses.
Similar to comparative analysis, a discount may need to be applied to your evaluation if you're using a publicly traded company as a benchmark for a private firm.
The limitation with this approach is that data can become outdated swiftly, necessitating regular updates for an accurate depiction of the prevailing market scenario.
8. Precedent transaction method
Like Comparable analysis, the Precedent transaction method uses the assessment of similar businesses in your industry as a benchmark for business value.
In this approach, you examine companies within your industry that have recently been sold or acquired.
This is especially beneficial if you're considering selling your business because these transactions often include a takeover premium reflecting the business's future value.
However, this method does have a drawback: the data becomes outdated rapidly, necessitating regular updates for an accurate representation of current market conditions.
If you're using a publicly-traded company as a reference for a private company, you might also need to apply a discount to your valuation.
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Making business finance work for you
Starting a business doesn’t come with a set of instructions.
We know that understanding the many different types of financial product in the marketplace can be difficult.
Our Making business finance work for you guide is designed to help you make an informed choice about accessing the right type of finance for you and your business.