Business valuation methodology
Regardless of your motivation or need for a business valuation, there are standard methodologies commonly employed to work it out. The skill of a valuer is in working out which methodology is most appropriate to the circumstances at hand. Unfortunately, there isn’t a one size fits all approach.
The trade value of a business is what a willing buyer is prepared to pay, and a willing seller is prepared to accept. The final value is only obtained by the purchase or transfer price, which is dictated by the buyer’s perception of desirability, comparative investments, risk and the net assets of the business.
It is possible to estimate the likely value of a business by assuming the perception of the buyer and relating this, to the profits and income/turnover generated by the business.
“Risk comes from not knowing what you are doing.”
The valuation of private companies/businesses is not an exact science. The purpose of valuing is to provide guidelines, which the parties to a proposed transaction may use when negotiating the price at which the business ownership can be transferred. The valuer is not bound to adopt one method of valuation and exclude another. Some valuations suggest that a combination of one or more methods may be needed to arrive at a fair value.
The most commonly used valuation methods are:
- Multiples of earnings method. This is probably the most common method for valuing profitable businesses. A valuation is worked out by taking the profits for the business and adjusting them for any unusual, one-off or non-recurring items (often referred to as “add backs”), such as consultancy fees or excessive overheads, to arrive at what is called 'normalised' earnings or profits. These normalised profits or earnings are then multiplied by an industry sector multiplier to arrive at a valuation.
For example, if a business has normalised earnings of £100,000 and a multiple of five is applied, then the valuation would be £500,000 (£100,000 x 5).
Smaller businesses are valued at a lower multiple than similar, larger companies. As a very general guide, smaller businesses can attract a multiple of between 2-4 times pre-tax profits and occasionally 5 or 6 times, if the business is forecasting very strong growth. Larger well established and highly profitable companies can have multiples of 6-10 times and more.
There are many factors which affect what multiplier to use, and specialist advice is recommended.
- Price Earnings Ratio aka PE Ratio is probably the most well know valuation model for investment in shares and company stocks. It is very similar to the multiple method above. It is a formula where the current Stock Market Price per Share is divided by the Earnings per Share (EPS). Simply put, it is a measure as to how much an investor is willing to pay for each £1 of earnings from the company.
The Price Earnings (P/E) Ratio is mostly used for valuing shares/companies listed on an established market, like the FTSE or AIM. PE ratios for listed companies are widely published in the financial press or can also be easily found online.
PE Ratios vary widely from industry to industry. When a PE ratio is applied to a small or non-quoted company, a heavy discount is often applied (25-75%)
- Discounted Cash Flow (DCF method). This is probably the most technically complex method of valuation. It is typically used for large, well-established businesses and is a favourite of the Private Equity industry. A DCF is used to estimate the attractiveness of investment by analysing the future cash flow projections rather than profits. By applying a discount rate to reflect for levels of risk, inflation and interest rates, it is possible to work out the present value of the cash flows today. This methodology takes into account the time value of money. A DCF is heavily reliant on assumptions made about future business trading conditions and isn’t suitable for all businesses.
- Net Asset Value. Also referred to as the net book value (NBV) method, is typically used for stable, well-established businesses which have significant tangible assets, such as property or plant and equipment and doesn’t reflect future earnings. This method is also often used for small and medium-sized businesses where the company’s profitability is low in comparison to its asset base. A value is reached by calculating the net realisable value of all the assets and deducting all the liabilities. Adjustments often need to be made to reflect current economic trading reality. This method is also referred to as the net book value (NBV) method.
- Entry cost method. This is where you compare an existing business value against the cost of starting a similar business from nothing. To calculate the costs, there are a variety of factors to consider, for example, the cost of raising the necessary finance, purchasing suitable assets, establishing premises, developing the products and services, recruiting and training staff and building up a customer base.
- Industry Rules of Thumb or sometimes referred to as the industry precedent method. For lots of industry sectors where the buying and selling of businesses is very common, many rules of thumb for valuation have become well established. Professional services businesses such as accountants or lawyers are a good example of where this method is applied. The valuation of these businesses is typically made on a multiple of the sales revenues or fee income. The multiplier applied is usually a known industry standard range.
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