Valuing a business

How much is your Business worth and how can you increase its value? These are the two questions which should be foremost in the business owners mind.

The worth of a business really depends upon how much money a purchaser can make from it compared to the risks involved in taking it on. Past profitability and asset values tend to be just the starting point and it is often the more intangible factors such as key business relationships, key personnel etc. which provide the most value.

Follow the links below if you wish to skip to certain areas of information contained on this page.

Why Value The Business?
What Affects Valuations?
Valuation Methods
Intangible Issues

Why do we value the business?

There are four main reasons for obtaining a business valuation

1) To help buy or sell a business

By understanding the valuation process it can enable a business owner to

• Take steps to improve the real or perceived value of the business
• Decide the best time to buy or sell a business
• Negotiate better terms
• Complete a purchase more quickly

There is a better chance of a sale being completed if both the buyer and seller enter the process with realistic expectations

2) To assist in getting others to invest in the business particularly through equity

• A valuation of the business can help in agreeing a share price for new shares being issued

3) To create an internal market for shares

• A valuation can help buying or selling shares in a business at a fair price particularly when for example, a director is retiring and wishes to sell his shares

4) As a vehicle in helping to provide motivation for management

Regular valuations of the company is a good discipline which can

• Provide a measurement yardstick for management performance when they see how they are increasing the net worth of the company
• Enables management to focus on important issues
• Help to expose areas of the business which need changing

All companies that are listed on a stock exchange have the quoted share price as a constant indicator of how well a company is doing. Unlisted companies need to do this in a slightly different way

There are three basic criteria which can affect the valuation of a business

1) The circumstances of a valuation

• An ongoing business can be valued in a number of ways (see later)
• A ‘forced sale’ will down value a company eg should an owner manager need to retire through ill health he may have to take the first offer that comes along. This is known as a fire sale.
• If the business is being wound up the break up value will be the net of the realisable value of the assets less liabilities outstanding

2) What is the value of the tangible assets of the business?

• A business which owns property or machinery for example will have substantial tangible assets
• Often businesses have no tangible assets beyond the value of its office equipment. This is particularly true of many service companies such as accountants and insurers.

3) What is the age of the business?

• A fairly new business may well have a negative net asset value but have an extremely high valuation in terms of future profitability especially where there are substantial long term contracts in place

Valuation Methods

Whatever the business is valued at with any techniques it must be remembered that this is a guide only. The true value of a business is what the purchaser is willing to pay for it . To arrive at this figure buyers will use various valuation methods and often a combination of methods. The main valuation methods are based upon:

1) Assets

This method would be appropriate if the business in question has significant tangible assets eg. a property company.

Basically the value of all the assets (both fixed and current) are added together and then the total of the business liabilities are subtracted from these to produce an asset valuation. The starting point for an asset valuation is to take the assets that are stated in the latest accounts (This is known as the ‘net book value’). This is refined to reflect the economic reality, for example, property prices may have increased substantially but their increase may not be reflected in the accounts, stock held may be old and have to be sold at a substantial discount or debts within the business may be ‘bad’ and therefore not likely to be paid.

2) Price/Earnings ratio

It would be common to use this method where a business is making sustainable profits which it has demonstrated over a number of years.

The price/earnings ratio (Known as the P/E ratio) is calculated as the value of a business divided by its profits after tax. Once the appropriate P/E ratio has been decided upon it is multiplied by the businesses most recent profits, its average profits over x number of years or on the calculated future profits(where contracts are in place and higher future profits can be justified).

P/E ratios are normally used to value businesses with an established history.

It should be noted that quoted companies will have a higher P/E ratio than unquoted. This is because their shares are much easier to buy and sell as there is a ready made market place and this therefore makes them much more attractive to potential investors.

P/E ratios are often adjusted by commercial circumstances, for example a higher forecast profit growth will result in a higher P/E ratio as will businesses which have constantly earnt profits

3) Discounted future cash flows

This calculation is appropriate for businesses which are forecasting a steady or increasing cashflow in future years possibly as a result of an heavy investment programme. This method is the most technical way of valuing a business and relies heavily on assumptions regarding long term business conditions.

The main uses of this method are for cash generating businesses which are stable and mature, eg a publishing company with a substantial catalogue of best selling titles.

Where a business can inspire confidence in its long term prospects this method will underline the businesses solid credentials.

4) Costs of Entry

This method values the business with reference to the probable costs involved to start up a similar business from scratch. Costs included in the valuation would include purchasing similar assets on the open market, developing its products and processes, recruiting and training employees and building up the customer base. The business would also benefit from any cost savings that could be made by for example, using better technology or locating the business in a lower cost area with a cheaper labour pool. Once this is evaluated the business is then able to make a comparative assessment which can be based on a more realistic scenario of the cheaper alternatives.

Intangible Issues

As stated at the beginning, a key source of value to the business can often be things which cannot be measured.

• Key relationships

A key example cited was strong relationships with key customers or suppliers eg where an extremely good relationship has been developed with a key supplier by paying on time, supplying key forecast information to enable stocks in the supply chain to be kept to a minimum or providing technical expertise to develop jointly key components.

• Management Stability

This may be a critical decision in the potential value of a business - particularly in owner managed businesses - where key information about the business resides with the owner. Should he leave then the business would be worth far less eg the profitability of a design agency may plummet if the key creative person leaves or if key sales people leave and take their accounts with them.

• Restrictive Covenants

These terms in employees contracts could add value to a business by ensuring that key personnel are restricted from moving elsewhere or conversely could reduce the value to a potential buyer if they intend to bring their own management team in.

• Risks

The more potential risks that there are from the purchasers point of view, the lower the valuation will be.

Specific actions can be taken to build a more valuable business

• Setting up good systems eg good accurate management accounts. Good systems make nasty surprises unlikely.
• Ensure that sales are spread across a wide customer base. Where there are few large customers the potential for disaster from the loss of just one is increased substantially.
• Ensure that key customers and suppliers are tied in with contracts and mutual dependence.
• Exposure to other external factors such as interest or exchange rates should be minimised.

Should you wish to have your business valued or analysed to increase its value please do not hesitate to contact us on 01384 468320 or via e mail at enquiries@alphalimited.co.uk and we will be only too glad to help.

Edmund house, 27 St. James's Road, Dudley, West Midlands, DY1 3JD