Valuing a Business

Valuing a Business
Last updated: 7/11/2008 View printable version

Selling your business will probably be the largest financial transaction you will ever undertake. Getting the right price is crucial.

You will have worked hard over years, maybe even decades, to build a successful company, and will want to maximise the amount you receive; realising its full value will be the ultimate reward for all your hard work and dedication.

And going into a potential deal with an idea of the figure you expect to negotiate enable you to manage the process far more effectively.

Before thinking about approaches to the so-called ‘art’ of valuation, you should consider your reasons for selling. Most advisors recommend formulating an ‘exit strategy’ before you even start a business; selling it when you have achieved your objectives, financial or otherwise, is the most common route.

Selling for the right reasons

Although many business owners continue driving forward well beyond their planned exit point, it’s worth remembering the old maxim: “it’s better to sell out than burn out.” Why not cash in while you are still young and healthy and enjoy the proceeds from all your hard work?

But even in a successful business, a sale can be precipitated by other factors – personal problems, for example, or disagreements among partners or directors. You might receive an unsolicited approach from a company, offering unimaginable amounts of cash for your business. More commonly, you might realise that the current economic climate is ideal for a seller – and not necessarily because of any wider indicators (unheard of purchase prices for similar companies, for example).

Too many sellers choose to exit when their business enters a downturn, when the value of their business looks lower to vendors. In an ideal world, you should aim to sell when your business looks set for growth: when turnover and profit is up, and when buyers will be desperate to get a share of the action.

Of course, some businesses are sold because the owner feels they are unsuccessful or are likely to become so in the future – but this doesn’t mean they are worthless. The right vendor – one that knows the sector – could find a business like this more attractive than a thriving one, because he or she might have the capital or resources to provide the missing link that would trigger growth and quickly boost its value. Even if a company isn’t a ‘cash cow’, it will, in most cases, have some form of assets, real or otherwise, that will represent value to the right buyer.

Valuation is an art, not a science

Understanding the valuation process will allow you to understand the ‘mind’ of that buyer. It will also help you to maximise the value of the business – by realising what you need to do to prepare a business for sale.

Many commentators claim valuation is an art, not a science. Renowned financial journalist Michael Brett once quipped that, in that case, it is the only form of art that regularly appears on company balance sheets.

What is really meant by this phrase is that valuation involves a lot of guesswork and lateral thinking. There is no ‘right’ figure – it could be worth half as much to one buyer as another. If your main product is a widget and demand suddenly surges in Brazil, this ratio could be one to three, or one to 10 if investment bankers have suddenly decided to take an interest in your sector.

If you are selling a house, valuers can use the sale price of other houses in the same street that were sold recently to reach a figure. But this method does not work well in valuing a business: it is highly unlikely that one with the same number of employees in the same part of the country will have been sold within the past month or so.

Valuations, even when carried out by experienced corporate financiers, can go horribly wrong – for example, Ford bought Kwik-Fit for £1bn in 1999, only to sell it for less than half the price three years later. Conversely, there are a host of examples of stock market analysts criticising acquisitions that subsequently outperform all expectations.

Nevertheless, there are four ‘models’ you should consider using to estimate the right price for your business:

• asset-based,
• price/earnings ratio,
• entry cost and
• discounted cash flow.

Some are more appropriate to particular sectors or company types than others, but there is no absolutely correct approach for any business.

Throughout the process, you will need to bear in mind what ‘components’ your business has: the assets it owns, the goodwill it has with customers and suppliers, and the expertise of its employees.

The asset-based approach is the most conservative of all valuation models. It is appropriate for businesses such as property companies or manufacturers, where assets form a large percentage of the ‘worth’ of the business (in the former case, buildings or development sites; in the latter case, expensive tools or machines). This method gives you a rough idea of the minimum price you can expect to negotiate – a financial comfort blanket.

To use this method, you simply add up the value of your assets and subtract any liabilities. Using the figures in your accounts – the net book value – is a good starting point, but remember that accountants are obliged to be prudent; they must give the minimum the assets could be sold for.

You will need to adjust those figures to reflect changing circumstances and market value. For example, have assets gone up in value? Or would they be difficult to dispose of, whatever the original cost? Has your accountant exaggerated the possibility of bad debts? In your calculation of liabilities, remember to include the company’s obligations – for example, rent or redundancy payments.

Price/earnings ratio

The price/earnings ratio is usually the most familiar valuation method to people with a modicum of business knowledge. It’s the most common way that analysts compare the values of companies quoted on the stock exchange. It’s not always appropriate for smaller, unlisted businesses as it can only really represent the value of established companies with a history of steady profit.

A value is determined using this method by dividing the market value per share by the post-tax earnings per share. So if the value of a single share on the stock market is 100p and the post-tax earnings per share are 5p, then the price/earnings ratio is 20. This means then that the business will be valued at 20p for each 1p of current earnings. So the higher the ratio, the higher the value you place on the business.

According to the Institute of Directors (IoD), a small unquoted business is usually valued at between five and 10 times its annual profit, depending on its history, potential and other market factors; a large, growing quoted company with good prospects can have a P/E ratio of over 20.

The IoD recommends looking at newspapers such as the Financial Times to gauge historic price/earnings ratios for companies in your sector, and adjusting them accordingly – it says that the P/E ratio for a small private company is around half of that of a listed company in the same sector. However, it is very difficult to get figures for comparison for other privately owned enterprises, as the details of the actual deal will remain confidential, with speculation in the trade press or clauses tying in the vendor often inflating the real figure.

Nevertheless, it should be possible to get a rough range for the P/E ratio. And of course, as mentioned earlier, you will have begun preparing your business for sale well in advance of making any concrete plans, taking measures to increase the apparent profitability of the business.

Calculating entry cost gives you an idea of how much it would cost to build a start a business and build it to the same size and with the same profits as the one being sold. To do this, you have to work out how much it would cost to purchase your assets all over again, develop the products, recruit and train the workforce, and build up a customer base – all from scratch.

You must also be quite brutal with your business and put yourself in the buyer’s shoes: if the business was located elsewhere, or used different raw materials, would it have a lower entry cost?

Finally, there is the most technical of all methods: discounted cashflow. Like the price/earnings ratio, it is best used for businesses that are stable, mature and generate cash, i.e., enterprises in which you have confidence that the returns and profits will at least match the historic values for the next decade or so.

To calculate this, establish the estimated profits for a given time period in the future. You then adjust this figure to take account of the diminishing value of money over time. How much would you have to leave in an account, at current bank interest rates, to produce those profits over that period of time? This will give you a ‘base figure’ for how much a person might be prepared to pay – but any company will be riskier than investing in a savings account. So replace the bank interest rate with a higher figure reflecting that greater risk (which will produce a lower initial sum).

For example, a company makes a profit of £10k per annum, which is forecast to remain steady for the next 10 years. Let us assume our potential buyer wants to achieve a 10% rate of return. But £10k received in five years time is not worth the same as £10k received today – because if I received that £10k today I could put it in a bank (where let us assume there is a 5% interest rate) and in five years time it would be worth £12,763. Working backwards, then, £10k received in five years’ time is actually worth £7,835 today, whereas £10k in 10 years’ time is actually worth £6,139 today. Adding all these figures together will give the buyer an idea of how much he should pay now to receive the returns from the business in the future.

Although there is no right approach for any one business, certain industry sectors use industry-standard ‘rules of thumb’ as shortcuts to valuation. These quick rules are also commonly used in the trade press to discuss the dynamics of the industry. For example, investment management companies are rated on the percentage of fund under management; estate agents are valued on the number of branches they have; and suitable prices for nursing homes are worked out on the basis of the number of beds. Retail and leisure businesses – such as pubs – tend to use standard multiples of turnover or profit after tax.

The ‘multiplier’ used when calculating the value in this way will vary depending on the security of the income. Sectors in which personal relationships are of paramount importance tend to use lower multipliers than asset- or technology-reliant businesses, for obvious reasons.

If you or your colleagues are an obviously key ingredient of the company’s success, buyers may well offer a higher price if you are prepared to commit to staying on as an employee or consultant for a fixed period of time. This reduces disruption and smooths the transition to new owners. However, the buyers may offer to pay a second sum at the end of that period – a risky route if they already own companies that are not entirely solvent.

Whatever the sector, though, buyers tend to regard bigger businesses as more secure – they have greater resources with which to weather any unforeseen economic storms. Buyers will pay more for such reliability.

Businesses can have other advantages that will increase the security of their profits. For example, a business might have intellectual property rights over a particular manufacturing process, recipe or marketing logo; or it might have a contract with a major multinational or with the government.

The nature of the buyer

Finally, the value of the business will also depend on the nature of the buyer. Acquirers will generally fall into two categories:

• financial and
• strategic.

A financial buyer, such as a venture capitalist, will generally look at your business in isolation, analyse the viability of its profits, and examine whether it could increase them if it were to streamline the company.

A strategic buyer, on the other hand, will be in the same or a related sector. Combining your business with his might enable him to cut costs in a way not possible for the financial buyer. He could centralise the sales and marketing function, for example. This type of buyer is also likely to have a greater understanding of – and faith in – the sector, and, consequently, your business model.

But while strategic buyers tend to be able to offer higher sums, they are few and far between.

Approaches from competitors are also dangerous. Do you really want to give a potential buyer divulge the mechanics of your business, only for him or her to abort the sale and remain a competitor? Then, he or she would be equipped with knowledge of your weak points, which he or she could then exploit, and your strengths, which he or she could then replicate?

One of the great advantages of knowing about valuation techniques is that it allows you to see what steps you can take to increase the value of your business.

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