There are many reasons why it might be necessary to value your business. But what are common methods and what do they involve?
A director of a company might want to sell to another or the owner-manager might even be getting divorced. They might need to raise equity capital or be contemplating the sale of the business. A valuation is required when issuing shares or granting options.
Valuing is sometimes used to chart progress of the business, for example, in family-owned firms, members might want to know what the business is worth each year.
The common cliché is valuation is an art and not a science. However, there are quasi-scientific valuation methods, but there is a subjective element to the process.
Profit and earnings:
When valuing trading companies (as opposed to investment companies), bottom line is generally a key factor. The much-used accounting term EBITDA (earnings before interest, taxes, depreciation and amortisation) represents the sustainable cash profits of a business assuming nil borrowing costs. To arrive at a valuation figure, earnings are often multiplied.
The important issue is profit going forward, not what profit has been achieved in previous years. A buyer wants to know what they stand to gain. A business will be more valuable if it has a rising rather than flat profit trend.
Discounted cashflow (DCF) is a valuation method that uses future cashflow and profit projections (over at least a five-year period) and discounts them back to arrive at a present value of the business.
Although commonly used to assess potential investments, the problem is you are dealing with estimated figures. There are no guarantees. Profits might be higher or lower. Discounted cashflow is fairly speculative for smaller businesses.
When carrying out such a valuation the current owners might be taking out more than a commercial level of remuneration. In which case, some of that excess can be added back into the profit figure before multiplication takes place. You have to normalise earnings before multiplying.
There are certain sectors where business valuations are usually based on multiplying turnover rather than profit. For example, professional partnerships, where one firm wants to take over another, where there's a good stream of turnover coming in. The larger firm might want to acquire that turnover and save costs by using their existing administrative set up.
Multiples vary considerably between and even within sectors. Larger companies are usually valued at a higher multiple than similar, smaller businesses.
Are tangible assets a factor when valuing a trading company? Not necessarily, unless, for example, the company owns its own freehold property. Net assets are central to the valuation of investment companies.
Intangible assets, such as reputation, relationship with suppliers and intellectual property, can be difficult to value. Naturally, any liabilities, such as level of debt, must be factored into any valuation. External factors, such as the wider economy, state of your market and value of similar businesses can have a bearing, particularly when you are valuing your business with a view to selling it.
A common mistake is valuing a business too highly, this is often the result of overly optimistic or deliberately inflated forecasts, when there's no real evidence to support such claims. This will lessen your credibility, because any credible purchaser will very quickly disregard your valuation.