Net asset valuation
This is the simplest way of valuing a business and is particularly appropriate for those with significant tangible assets operating in a relatively stable market. The net assets figure, equal to the net worth, is shown on a business's balance sheet. In theory, if everything was sold at the value recorded on the balance sheet, the amount of money raised (minus any liabilities) would be equal to the net assets.
Multiple of net earnings (P/E ratios)
A business can also be valued using its average historical net earnings (net profits after tax). This valuation assumes the business will continue to generate these average profits into the future, and the valuation is based on a multiple of these earnings. A typical price-to-earnings (P/E) ratio range used for small businesses is two to seven times average earnings, with the actual multiple chosen being dependent on the perceived risk of the business and its growth potential.
In some sectors, business valuations can be derived from factors other than asset valuations or net earnings figures.
Certain types of business (such as milk rounds, newsagents, estate agents and post offices), which are bought and sold on a regular basis, can be valued based on accepted critical factors to business success. For example, the value of a milk round is closely associated with its average daily delivery, and estate agents can be valued according to the number of branches they have.
Cost of entry
Another method of valuing a business is by calculating the cost of setting up a similar venture from scratch. Costs that need to be considered include hiring and training staff, buying equipment, developing the products or services, and marketing them to existing or new customers. It is also necessary to factor in the time it will take to carry this out, and to determine the perceived risks of this approach. This cost can then be compared with the advantages, namely the goodwill value, of buying an existing business that has an established reputation and customer base.
In some mature markets, an individual business may have little value based on its financial performance, but it can have considerable value to a competitor because of the pool of loyal customers that the business may have built up. In these circumstances, a buyer will look at the potential income stream from these customers, whom they may be able to service through their existing business, or with a considerably lower cost base than the current operation incurs. A valuation can then be calculated based on the turnover or expected gross profit contribution of the business.
Multiple of revenue
If a business is not yet making a profit, for example because it is still very young and becoming established, it is possible to use a multiple of revenue rather than a multiple of earnings. However, this is even less precise since there is no guarantee that the business will ever show a profit. A useful approach is to find other similar businesses to derive a suitable multiplier - remembering to apply a discount if the businesses that are used for the comparison are listed on the London Stock Exchange.
There are several additional factors to consider when valuing a business. These may be difficult to quantify, and they can either add significant value to a business or reduce its value by highlighting risks to a potential purchaser. These include the following.
Market and external factors
What is happening in the market in which the business operates? What are the trends affecting the sector? Important considerations include size, growth, changes in technology, regulations, and any political and economic factors. Does the business have a growing or declining market share? Who are the competitors of the business, where are they located, and what are their strengths and weaknesses? Are there similar businesses being advertised for sale, and do they have a quoted sale price?
Customers and suppliers
Is the business dependent on one or two major customers to the extent that it could suffer a major loss of income if a contract is lost? Or does it have a diverse customer base that means the business could sustain some loss of customers? Does the business generate recurring income from its customers, or does it rely on one-off sales from new customers? Does the business have good relationships with its suppliers? Does it have a large choice of suppliers, or is the business dependent on one or two key firms? Does the business have robust contracts with key customers and suppliers?
Is there a stable workforce, and are the employees well trained? Does the business have established processes and systems that reduce dependence on one or two individuals? This factor can sometimes be a problem, particularly with sales or creative businesses where a large part of the value of the business lies with the owner or other key employees. Are the assets owned by the business well maintained? Is there clear ownership over intangible assets such as intellectual property, or are there formal agreements in place for licensing and patent rights?
An accurate valuation is an important way to get an overview of the strength and sustainability of the business, identify any weaknesses and make plans for its future. Below, we describe different methods used to value a business and which methods are best suited to different types of enterprise.
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