What's My Business Worth (Part I)
It’s something you probably need and want to know but may struggle to answer. You could just assume it’s worth whatever someone else is prepared to pay for it. But when it comes to selling your business it‘s important to have properly calculated at least a rough figure of the value in your business.
Apart from being the starting point for negotiations it will also more importantly, give you a realistic idea if the sale is going to give you the money you need in later life.
Unfortunately, there is no single formula that can be used to determine the precise value in every business. Business assets, in most cases are comprised of both tangible (turnover, profit, stock) and intangible (brand, trademarks, customer base, staff etc.). It’s easier to calculate the price on the former, but not so the latter.
So let’s have a look at the most commonly used techniques for calculating the value of a business.
The Price / Earnings Ratio represents the value of the business divided by its post-tax profits. It’s a good way of comparing your offer to other trade sales of businesses in the same industry.
As an example, if you were offered £250,000 and your company is making annual post-tax profits of £50,000 the P/E ratio would be 5 (£250,000/£50,000). But what does that mean?
P/E Ratio is more commonly used to value bigger, often FTSE listed, companies, where comparisons to trade sales and industry competitors are more readily available. It’s also more relevant where there is reasonable business stability.
The ratio is often used by stock market investors to calculate if the share price of the company they are investing in is over or under priced.
Smaller businesses are more likely to be impacted by a major change, such as a change of founder, loss of a major customer, supplier or member of staff. As result, they’re seen as having a higher risk and this is often reflected in a lower P/E ratio.
Similar to the P/E ratio, this is a method based on earnings. The figure used is often calculated by looking at earnings before interest, tax, depreciation and amortisation costs (EBITDA) are removed and then multiplying the EBITDA figure by a commonly accepted industry multiplier. By finding out what is generally used in your industry, you can ball-park your company’s value and because it is an easier to understand method, it is the one most often used.
At its essence the multiplier generally reflects the number of years of cash-flow your business is worth.
It’s easy to say 4 times value is the multiplier being used in my industry, so if I’m making an EBITDA of £250,000 my business is worth £1m+.
That’s not to say however that because your industry assumes a certain value is being widely used or a competitor has been sold for a certain value, you are going to naturally get that multiplier. A business operating with a lower cost income ratio than yours or has a greater degree of recurring income, rather than relying on constant new orders, is going to attract a greater multiplier.
Using a multiplier only gives a rough guide as to your value. It’s not gospel and a prospective buyer will soon chip away at your assumed price if the other parts of the business are not up to scratch.
Discounted Cash Flow (DCF)
Here we assume the value of the company is the sum of its future cash-flows over a certain timeframe. By forecasting the company’s cash-flow (or future profits) and then discounting for the time cost of money, we arrive at a present value of the business.
The key points to note are:
- The accuracy of the future cash-flows is important so several years of good accounts and an excellent business plan will be required to demonstrate the potential value of your business.
- The time period chosen. If your customers are contracted to you over a long period, the number of years used can be greater than, say, retail ad-hoc customers.
- The effect of the discount rate.
When using this methodology, we often look at where else a buyer could put his money. If he invested in the stock market maybe he could expect a return of 6% and use that as the discount rate.
So what does that mean in practice? If we assume a business makes annual post-tax profits of £50,000 for 5 years and assume a discount rate of 6%, the present value of the business comes to £210,618.
If the potential buyer thought the purchase was more risky and so chose a higher discount rate of 9%, the calculated present value would be £194,483.
Forecasting future profits can be a dark art and any estimates need to be backed up by both past history and good evidence that future profits are achievable. In calculating values, we have often used both qualified figures and planned numbers to show more clearly the link between past performance and future expectations. Backed up by a bloody good business plan.
The methods I have outlined above are the main ones used to measure value in your business. In my next article I will cover some more ways you can claculate what your business is worth.