How to value your business
For most business owners, their business is their largest single asset. All businesses should be built to sell but selling a business is often a “once-in-a-lifetime” event, so it pays to know what it is worth.
This post is designed to help you understand better how to value your business and give you an appreciation of the maths involved. However, business valuations are a mix of subjective judgement and maths. Business valuation is an art as much as a science and there are no right answers.
The science behind the maths can be learned but the basic principles are straight-forward. The subjective elements vary from individual to individual which is why two buyers reviewing the same set of financials may come up with wildly differing valuations when appraising a potential business acquisition.
This article looks at the basic maths behind the three most common business valuation techniques, but this is only a general guide. Each buyer’s circumstances will influence how they interpret these basic techniques. In a small number of cases where the buyer is a “special buyer” or “strategic buyer” higher valuations are possible because there are additional synergies or benefits available to that particular buyer. We focus here on the main three valuation techniques and suggest you use these to produce a range of valuations that you can interpolate to produce your valuation.
The simplest way to value a business is to consider the value of its assets less its liabilities. A manufacturer with machines and a factory will often have substantial tangible assets. However, a software developer will probably have few fixed assets but may have substantial intangible assets such as goodwill, know-how and intellectual property rights.
With the rise in knowledge work, the lack of a universally acceptable framework for intangible assets makes asset-based valuations problematic as most intangible assets will either not be reflected on the Balance Sheet or included at an obsolete historic cost.
Therefore, asset-based valuations can produce the lowest end of the range of valuations because they do not include realistic valuations of any intangible assets.
One definition of goodwill is the difference between what a buyer will pay for your company and the value of the net assets less any liabilities. Most businesses have some goodwill so using one of the earnings-based techniques will produce a higher valuation.
Discounted Cash Flow
This method looks at the cashflow generated after paying all liabilities as they fall due. Cash flow ultimately is driven by the earnings of the business but is preferred because cash flow numbers cannot be manipulated to the same degree as profits or earnings can. This method estimates what the future cash flow stream is worth in today’s money as the tie value of money means that £100 in a year’s time is worth less than £100 today.
The starting point is to estimate the future maintainable profit for the next 3-5 years, after removing exceptional items and non-business personal expenses. From this the likely future maintainable cash flow can be estimated after allowing for working capital requirements, loan repayments, tax payments and capital expenditure required to continue the business.
After estimating the future cash flows, the buyer can now consider what the business is worth now and what it might be worth when they come to sell it in future. They will apply a discount rate to account for the time value of money, and this rate is determined by the buyer’s cost of capital and their view of the risk
Understanding the maths is less important than understanding the “drivers” of your value when using this method, which are: -
- how much profit is the business expected to make in the future?
- how reliable are those estimates?
When the Discounted Cash Flow method is being used, the assets of the company are ignored as they are assumed to be included with the generation of the profit.
The third common valuation technique is to look at the value of comparable businesses that have been recently sold. The difficulty is that often with private companies, the price is not publicly disclosed. In some sectors, valuations are common using sector-specific rules of thumb. For example, accounting firms are typically valued at 1-1.5 times their gross recurring fee income.
The problem with using comparators is that it is hard to find similar businesses and it is easy to make erroneous comparisons by not comparing like with like. Kier plc a FTSE 350 engineering and construction group was valued at 217 times earnings on 3rd September 2018, but a small private engineering and construction group will probably have a PE ratio of around 5 times annual earnings. This is because they may share the same industry, but they will be in a differing segment due to size and scale of operations, making direct comparisons problematic.
It is normal to heavily discount public sector valuations when using them as comparators for smaller businesses.
Whatever valuation a seller comes up with, it is usually the buyer who gets to choose the most appropriate valuation method based on what the business is worth to them. If they are a special or strategic buyer, they may be prepared to offer a generous price because they expect to unlock some other synergies perhaps by merging with an existing business. However, most buyers are not special buyers and they will pay a price that makes sense to them based on their calculations of what the business can generate for them. They will probably compute a range of valuations using the methods above and pitch an offer somewhere within that range.