Knowing what your business is worth at any one time is important for several reasons. It can help you understand how to add more value, or where you might be carrying unnecessary weight.
Valuing a business is also useful if you need to guarantee loans, or to get a fair price if you’re selling. Any potential buyers will be keen to know how much money they can make from the business going forward, as well as where the risks lie.
We look at the different ways in which you can work out the value of your business – and why it’s important in the first place.
Why would you want to know?
When it comes to valuing a business, there are generally three main reasons for wanting to do so, which we look at below.
When you’re looking to sell or grow your business.
Only when you know the true value of your business can you work out the best ways to increase it.
Maybe you need to upgrade your equipment or buildings for example, and need to understand the current value as a starting point. It can also help you enter the selling process with more realistic expectations.
Goal setting and motivation
Not only can regular valuation help measure and incentivise business performance, it’s a chance to focus on issues that are important to the company.
So, as well as understanding the overall value of the organisation, breaking it down into areas can help pinpoint your attention.
Perhaps you’re trying to increase your green credentials or transition the business online for example. An up-to-date valuation of your business can show you what to focus on for further growth and improvement.
Business valuation is a bit of an ‘art form’ – there isn’t one single ‘right’ way to do it. Business owners and brokers tend to use a number of methods so they can see the bigger picture more clearly.
Why? Because businesses are all individual and can be very complex. It’s like the old saying “a house is only worth what a buyer will pay for it”.
It’s similar in business; the value is very much in the eye of the beholder. That said, there are several common ways to value a business in the UK, which we’ll explain next!
If your business has a number of fairly sizeable tangible assets, then this way will probably work best. Tangible assets, things like stock and inventory, buildings, machinery, and equipment, have a ‘physical’ form, so it’s easier to measure their value. Intangible assets – things you can’t physically touch such as intellectual property or brand reputation – are more difficult to pin a value on.
The net value of your business assets (the tangibles ones at least) will show in your accounts, though you’ll also need to consider any asset depreciation or other liabilities. It’s why managing your assets properly is so vital.
The value of goodwill
It’s worth noting that simply valuing your business on its assets is often not the most lucrative method. It can be a little basic, as it assumes there is no ‘goodwill’ in the business which can be incredibly valuable.
This is the value of your brand in the marketplace – built up over time and recognisable to customers as a sign of quality assurance.
2. Price/earnings ratio
The price/earnings technique (or the multiple of profits) is best suited to businesses with a strong track record of good profitability. It works by:
Adjusting monthly or yearly profits to exclude any extraordinary events (like one-off large costs or purchases). This gives you a much clearer idea about your profits going forward.
Adding additional costs or gains made by the company once further investment has been made into it, or it is sold. This will generate a final profit figure, referred to as a “normalised profit”.
Multiplying the standard industry practice by normalised profit (generally 3 to 5).
The figure you then end up with will be your price-earnings ratio, giving you an idea of value.
This is a tried and tested method of valuing a business in the UK. It basically involves looking at what similar businesses have sold for in recent years, and coming up with a value for your own business accordingly.
It’s a bit like when you sell your house. You look around at what others of a similar size and spec have sold for in your area before deciding on an asking price.
4. Discounted cash flow
Discounted cash flow is a common way to value a heavily invested business that has been around for a long time and has a predictable, stable cash flow.
The only problem is, it’s quite a complex way of getting a valuation for your business. This method relies heavily on assumptions that can be made about future business conditions. But if COVID-19 has taught us one thing, it’s that life is unpredictable!
How does it work?
The discounted cash flow method provides a relatively accurate estimate of what a future cash flow stream is worth right now. The valuation is worked out as the sum of the dividends predicted for each of the following 15/16 years or so, plus a residual value given when this period ends.
The calculation for today’s value of future dividends is done by applying a discount interest rate (generally ranging from 15% to 25%). This considers the risk and the time value of money (based on the concept that £1 received today is of higher value than an equal amount received later).
If the business is worth more than the cost of investing in it, it’s an investment opportunity that could prove lucrative.
5. Entry cost valuation
This is essentially where a valuation for a business is worked out by estimating how much it would cost to start up an almost identical business from scratch.
It considers all of the various costs that would involve, including HR and staffing costs, buying stock, offering training, building a client base, and purchasing or leasing assets. Everything, basically!
6. Industry rules of thumb
Just about every industry has its own set way of valuing businesses within it. For example, retail outfits tend to be valued using a multiple of turnover, number of outlets or how many customers they’ve had.
But a different sector, such as a computer repair business, will usually only be valued by turnover. Estate agencies will be by the number of branches they have, and so on.
What is the best way to value a business?
Individuals and entities purchase businesses for a whole range of reasons, whether to reduce competition, increase customer numbers, or to merge with another brand.
Just like with house sales, the purchaser needs to know the value of what they’re buying. But as we mentioned earlier, this isn’t really a “one size fits all” thing.
Ultimately, you could use several different ways to value a business, and arrive at a different figure each time!
Buyer versus seller value
Negotiations between buyers and sellers can also mean the valuation fluctuates over time. For example, having a large fixed asset you believe is worth X amount, but your purchaser only thinks is worth Y will likely affect your final value.
As the seller of your business, you’re also more likely to want to highlight the profits your buyer could make, and why it’s a good return on investment.
The buyer will probably focus more on the risks. Realistic valuations are ones that take both these things into account.
In a nutshell, if you’re simply after a rough idea of what your business is worth then quickly adding up your assets may well be enough. But if you’re looking for something more detailed, then you’ll need to take many more factors into account.
How do venture capitalists value companies?
Before we finish, we thought it worth looking at business valuation from a venture capitalist (VC) viewpoint. Seeking to gain VC buy-in is, after all, another very common reason for wanting to know what your business is worth.
Professional investors, including venture capitalists, take a slightly different angle when it comes to business valuation. They do look at profit, assets and comparable companies, but they also set this against their exit valuation instead of their entry valuation.
Basically, venture capitalists begin with a financial projection they believe to be achievable, and work backwards.
They look at the rate of growth and apply an exit multiple from sensible comparable companies, plus a pre-determined rate of return. This allows them to calculate the amount of money they are willing to offer.
Bear in mind that this way of doing things means selling a high-growth business to a VC can be much more (or much less) profitable than selling to another business or individual.