How to value a small business
Want to sell your small business and not sure how much it's worth? Finance journalist Steve Sims lists and explains the factors for working out the value of a business.
- Common company valuation methods
- Price to earning ratio
- Entry cost
- Asset valuation
- Discounted cash flow
Any business is worth as much a willing buyer agrees to pay. But to gain the best deal the owner should know the answers to two vital questions before selling.
- How much is my business worth?
- Is there anything I can do anything to improve the value?
So the first step in valuing a business is to take a look from the buyer’s standpoint to consider the factors that affect the price.
A serious buyer will want to analyse the accounts as well as look at the intangible assets, such as goodwill, management and intellectual property. Sometimes, these intangible factors add more value than a business owner might believe.
Below are the most common reasons owners want to value their businesses.
- Buying or selling a business to work out whether the price reflects the true worth of the business
- To give potential investors an opportunity to see shares are fairly priced
- To set a value for debt finance
- To help management identify which parts of a business are performing well. Regular valuations help owners benchmark and review performance over a period of time
Regardless of what type of business you run, three basic factors affect the valuation.
Why are you selling the business?
A going concern is a business that functions without the threat of liquidation for the foreseeable future, usually regarded as at least within 12 month. This type of situation is likely to fetch the best price as the new owner will have an instant cash flow and customer base.
If you’re retiring or in ill-health, you’re less likely to pick up the top price for your business. Buyers will suspect the sale is forced and that you just want to take some money and run within a short timescale.
If you’re winding up a business, the value is much lower than selling as a going concern. Subtracting any debts from any assets will determine the valuation.
What are the tangible assets worth?
Tangible assets are plant, machinery and property. Service businesses tend to have few tangible assets and their real worth lies in their customer database. The value then is based on the potential profits those customers may generate.
Does the business have a good reputation?
A well-established business with a familiar brand that makes a regular profit is often worth more than a start-up that is making a loss.
Buying into a start-up is risky as the business has no trading history and the risk lies in growing the business to yield healthy profits
The trick is turning these basic factors into a valuation. To do this, accountants and business people can rely on several calculations and generally consider two or more from the below list.
- Price to earnings ratio
- Entry Cost
- Asset Valuation
- Discounted Cash Flow
The price/earnings ratio is worked out by dividing the profits after tax by the earnings ratio.
The available price/earnings ratios tend to cover public companies rather than private businesses. The higher the ratio, the better rated the business.
Expect these ratios for the following different businesses.
- 0 to 2.5 for owner managed businesses
- 2 to 7 for small businesses with profits up to £500,000 a year
- 3 to 10 for small businesses with profits exceeding £500,000.
For example, a small business has a P/E ratio of two and has after tax profits of £120,000, then the P/E valuation is worked out by multiplying the profit by the ratio, which gives £120,000 x 2 = £240,000.
Entry cost is how much an entrepreneur would have to invest to start a similar business to the one for sale.
To work this out, list the costs of financing the start-up and buying any tangible assets. Then factor in how much to spend on researching and developing products, staffing costs and working capital while building a customer base.
Subtract savings, like improving efficiency with better technology, sourcing cheaper raw materials, and locating in a cheaper area or online.
The entry cost valuation is then compared to the price of the business for sale to give a realistic yardstick of how to proceed.
Asset valuation does away with any calculation involving future earnings. The business price is simply what any assets are worth after subtracting business liabilities, such as loans, mortgages or commission owed, etc.
Use asset valuation for businesses with tangible assets, such as property and machinery that is owned and not rented. It can also be used when businesses have intangible assets like goodwill, trademarks or patents.
These values are generally found on the business balance sheet as the ‘net book value’, which is the cost price minus depreciation.
It’s worth bearing in mind some asset valuations need adjusting. For instance, property prices may have changed since the last professional valuation, debts may have been written off, while old stock may only shift with a heavy discount.
Discounted cash flow is a method of valuing a mature cash business rather than a start-up and makes assumptions about the likely future trading and profitability.
This value looks at the likely profits a company will generate over the following 15 years or so and the likely continuing value of the business at the end of the assessment period.
The ‘discount’ relates to the value of cash in the hand now, rather than what will be received at some point in the future. For example, £100 in the bank today is worth more than £100 in the bank in 15 years’ time.
Knowing the value of your business is important as you’re likely to better understand the risks you face and will have developed systems to iron out any problems.
Good management reporting, a system of action and review, and good relationships with customers and suppliers will make your business stronger and more valuable.
These are intangible assets that add value to a business and steps worth taking if you intend to take your business to market as an exit strategy.