What value is your business?

Most individuals can estimate how much their house is worth, but many business owners do not have a clear idea how much their business is worth.

There are many reasons for valuing a business; a potential sale, for life insurance purposes, to incorporate partnerships and sole traders, measuring the performance of a company for shareholders or simple curiosity.

The answer can be the same for a house as a business - the value is how much a third party is prepared to pay for it. However, whereas for a house the valuation is based on subjective factors such as location and appearance, there are established techniques used to value a business.

When considering the value of a business the basic principle is that it should reflect the current value of future returns – in the form of profits generated by the business or in the realisation of the assets held by the business.

Types of valuation method include:

1. A successful trading company is typically valued by reference to its future earnings. This is known as the earnings basis of valuation.

One such method involves applying a multiplier known as the price/earnings (p/e) ratio to post tax earnings. However, determining the p/e ratio for a private SME is largely a matter of judgement depending on the circumstances of the business.

The future maintainable profits may be assessed from budgets or projections if these are realistic and reliable. However, in many SMEs they are often prepared on an optimistic basis, if they exist at all.

Consequently, the recent historic results can also be used as a guide to the future earnings of the business, although adjustments should be made for any exceptional income or costs which would otherwise distort the figures. Thus a company which is expected to report post tax profits of, for instance, £500,000 per annum may be valued at £3-3.5m if a p/e of 6-7 is considered appropriate.

2. There are variations on earnings based valuations by applying multiples to earnings before interest and tax (EBIT), or before interest, tax and depreciation (EBITDA). Additionally, some valuation models involve discounted cashflow techniques analysing the returns each year from investments.

3. In asset based businesses such as property investment companies, farming or hotel groups the business may be valued using the underlying net assets of the company instead of the earnings.

4. Finally there may be industry-specific methods of valuation, eg professional practices, insurance brokers and petrol stations. However, even though there may be a particular formula the value is still based on future anticipated returns from the business.

Whatever valuation methods are used, the valuer should always consider the figure arrived at and ensure it is reasonable to the circumstances of the company. If the current earnings of a trading company are low, for instance £50,000 per annum but the net assets are £2 million then the earnings basis is clearly not going to provide a reasonable valuation simply by applying normal p/e ratios to the current level of profits. Further investigation will be required of why profits are so low and the realisable value of the assets.

Valuing the business is clearly important if the owner wishes to sell or reorganise the business. However it can be a useful business tool in setting targets and goals within the organisation to maximise future returns from the business. If the owners see the value of the business effectively as a pension then they need to keep an eye on how much it is worth and how such value can be increased in the future.