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:
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.
As stated at the beginning, a key source of value to the business can often be things which cannot be measured.
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.
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.
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.
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 firstname.lastname@example.org and we will be only too glad to help.