Six Easy Ways to Value a Business
Valuing a business may sound like a scary territory for some people. It’s easy to understand why some get intimidated by this discipline – you’re dealing with company valuations that determine how much a business is worth in the stock market. But one’s feelings towards this concept need not be hostile. Business valuations are harmless and there are less stressful ways of doing them. Here, we will introduce what they are.
To anyone dealing with this discipline, it is important to value businesses accurately because so much is at stake. Business valuations have the power to entice or deter investors.
Why would you value a business?
Apart from the trade happening in the stock market, business valuations are significant for the following reasons:
- Investment – valuing a business helps with the pricing of new shares issued
- Developing an Internal Market for Shares – a business valuation helps in making sure that shares are traded at a reasonable price
- Management – business valuations can also help amp up under-performing management and acknowledge good performances
A business valuation can be influenced by a lot of different factors. These include:
- The circumstances that surround the valuation (e.g., voluntary sale vs. forced sale)
- The business assets’tangibility (e.g., physical assets vs future profitability)
- The age of the business (e.g., an established company’s profit vs. an emerging company’s negative asset value)
But the factor that has the most impact on the value of a business is how much the buyer thinks it’s worth. Determining this value involves different valuation techniques.
How do you value a business?
An asset is a valuable item owned by a company. There are two types of assets: tangible and intangible. Tangible assets are a business’ physicial assets, like land and buildings, machinery, and inventory. On the other hand, assets that are non-physical are referred to as intangible assets. Examples are brand, goodwill, and intellectual property. Intellectual property includes patents and copyrights). Businesses that have a considerable amount of tangible assets often apply the asset valuation method.
With this method, the business’ net book value shows the total liabilities being deducted from the company’s total assets. However, inflation rates, and appreciation and deprecation values might not be considered, so, it is important to keep asset values updated.
When using the asset valuation method, there is a tendency for businesses not to maximise their value. This is because, in this valuation method, goodwill is not considered. Goodwill refers to the difference between a business’ market value and its net assets’ value. Thus, using the asset valuation method often means that the business’ value is actually lower.
2. Ratio of Price and Earnings (Multiple of Profits)
For businesses that have a history of high profitability, the price/earnings method of valuation is most applicable.
When using the price/earnings technique, the monthly and annual profits are adjusted to forecast future profits. This means excluding events like one-off purchases or costs. This technique also involves getting the final figure for profits by adding costs and gains after the sale of or investment in the company. The figure obtained is referred to as normalised profit. Lastly, in this method, the normalised profit is multiplied by three to five to get the price-earnings ratio. The common multiples applied for earnings can differ from one (used by doctors’ offices) to 25 (used by banks). However, the standard is three to five.
3. Entry Cost
Another technique is the entry valuation method. This is done by looking at estimated costs when a similar business is established from scratch. The estimates must consider the cost of manpower, training, product and service development, and building up assets, and establishing a client base.
4. Discounted Cash Flow
Mature businesses that have a steady income stream forecast and heavy investments often apply the discounted cash flow valuation method. This is said to be Warren Buffet’s technique of preference. An example of a type of business that could use this method is a stable energy company.
In the discounted cash flow technique, the future cash flow’s current market value is estimated. The valuation considers the sum of forecast annual dividends for the next fifteen years and with an added residual value at the end.
To obtain the current value of the future dividends, a discount interest rate, which may range from 15% to 25%, is applied. Of course, the risk and the time value of money are taken into account during this process. The time value of money simply refers to the concept that a certain amount of money today will have a higher value in the future. If the value of the future dividends obtained is higher than the current investment cost, then it is believed that the business is a good potential investment.
The discounted cash flow relies heavily on assumed long-term business conditions that is why it is seen as the most complicated business valuation method.
Another valuation method is done by comparing the value of a business with a similar company that is already available in the market are has recently been sold. How this is done is similar to how prices of real estate properties are calculated.
6. Industry Rules of Thumb
Businesses that operate within an industry use a standard formula during business valuation. For example, retail outfits are valued as a multiple of turnover, customer volume, or number of outlets.
Mail order businesses and and businesses that offer computer maintenance services, on the other hand, are valued by turnover, while business that provide airtime for, let’s say, mobile phones, are valued by the number of customers. Meanwhile, real estate agency businesses are valued by the number of outlets that they have.
Examples of Valuation
Golf Course Resort
The best technique to apply on a golf course resort that stands on a £5m property is asset valuation method. Even if the business suffers a significant amount of losses, the fact that it stands on a prime piece of property means that it is still rich in assets.
Virtual Law Firm
On the contrary, a virtual law firm that has a forecast average profit of £500,000 in the following year will have a higher valuation when using the discounted cash flow or comparables techniques. These methods are best for this kind of business because the business value of the virtual law firm lies in its future cash flow and not in its tangible assets. When compared to the projected income of £500,000, the physical structure where the virtual firm runs is rather negligible. Projected values are best evaluated using the discounted cash flow and comparables methods.
To get the best valuation results, investors or buyers usually use at least two methods of business valuation to obtain a range of values that will be used as basis of their decision.
All these valuation formula are used not only to estimate the price of businesses, but their value as well.
Entrepreneurs are given a kind of benefit where they gain something when they decide to give away or sell their business with lower tax rates. This benefit is referred to as Entrepreneur’s Relief (ER). Because ER reduces the amount of Capital Gains Tax that you need to pay during the sale of your business or shares of a business, it is important for company owners to be aware of this benefit so they can take advantage of it when necessary.
An Accountant’s Value
To avoid the hassle of working out the value of your business, it is always advisable to speak to a qualified accountant. Accountants can help you understand certain figures and how they can impact your business.