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Four models of business valuation

Dollar note money cash

Throughout the business valuation process, you will need to bear in mind the 'components' your business has: the assets it owns, the goodwill it has with customers and suppliers, and the expertise of its employees.

The asset-based approach is the most conservative of all valuation models. It is appropriate for businesses such as property companies or manufacturers, where assets form a large percentage of the 'worth' of the business (in the former case, buildings or development sites; in the latter case, expensive tools or machines). This method gives you a rough idea of the minimum price you can expect to negotiate - a financial comfort blanket.

To use this method, you simply add up the value of your assets and subtract any liabilities. Using the figures in your accounts - the net book value - is a good starting point, but remember that financial advisors are obliged to be prudent; they must give the minimum the assets could be sold for.

You will need to adjust those figures to reflect changing circumstances and market value. For example, have assets gone up in value? Or would they be difficult to dispose of, whatever the original cost? Has your accountant exaggerated the possibility of bad debts? In your calculation of liabilities, remember to include the company's obligations - for example, rent or redundancy payments.

The price/earnings ratio is usually the most familiar valuation method to people with a modicum of business knowledge. It's the most common way that analysts compare the values of companies quoted on the stock exchange. It's not always appropriate for smaller, unlisted businesses as it can only really represent the value of established companies with a history of steady profit.

A value is determined using this method by dividing the market value per share by the post-tax earnings per share. So if the value of a single share on the stock market is 100¢ and the post-tax earnings per share are 5¢, then the price/earnings ratio is 20. This means then that the business will be valued at 20¢ for each 1¢ of current earnings. So the higher the ratio, the higher the value you place on the business.

A small unquoted business is usually valued at between five and 10 times its annual profit, depending on its history, potential and other market factors; a large, growing quoted company with good prospects can have a P/E ratio of over 20.

You could look at financial newspapers to gauge historic price/earnings ratios for companies in your sector, and adjust them accordingly - the P/E ratio for a small private company is around half of that of a listed company in the same sector. However, it is very difficult to get figures for comparison for other privately owned enterprises, as the details of the actual deal will remain confidential, with speculation in the trade press or clauses tying in the vendor often inflating the real figure.

Nevertheless, it should be possible to get a rough range for the P/E ratio. And of course, as mentioned earlier, you will have begun preparing your business for sale well in advance of making any concrete plans, taking measures to increase the apparent profitability of the business.

Calculating entry cost gives you an idea of how much it would cost to build a start a business and build it to the same size and with the same profits as the one being sold. To do this, you have to work out how much it would cost to purchase your assets all over again, develop the products, recruit and train the workforce, and build up a customer base - all from scratch.

You must also be quite brutal with your business and put yourself in the buyer's shoes: if the business was located elsewhere, or used different raw materials, would it have a lower entry cost?

Finally, there is the most technical of all methods: discounted cashflow. Like the price/earnings ratio, it is best used for businesses that are stable, mature and generate cash, i.e., enterprises in which you have confidence that the returns and profits will at least match the historic values for the next decade or so.

To calculate this, establish the estimated profits for a given time period in the future. You then adjust this figure to take account of the diminishing value of money over time. How much would you have to leave in an account, at current bank interest rates, to produce those profits over that period of time?

This will give you a 'base figure' for how much a person might be prepared to pay - but any company will be riskier than investing in a savings account. So replace the bank interest rate with a higher figure reflecting that greater risk (which will produce a lower initial sum).

For example, a company makes a profit of $10k per annum, which is forecast to remain steady for the next 10 years. Let us assume our potential buyer wants to achieve a 10% rate of return. But $10k received in five years time is not worth the same as $10k received today - because if I received that $10k today I could put it in a bank (where let us assume there is a 5% interest rate) and in five years time it would be worth $12,763. Working backwards, then, $10k received in five years' time is actually worth $7,835 today, whereas $10k in 10 years' time is actually worth $6,139 today. Adding all these figures together will give the buyer an idea of how much he should pay now to receive the returns from the business in the future.

Although there is no right approach for any one business, certain industry sectors use industry-standard 'rules of thumb' as shortcuts to valuation. These quick rules are also commonly used in the trade press to discuss the dynamics of the industry. For example, investment management companies are rated on the percentage of fund under management; realtors are valued on the number of branches they have; and suitable prices for nursing homes are worked out on the basis of the number of beds. Retail and leisure businesses - such as bars - tend to use standard multiples of revenue or profit after tax.

The 'multiplier' used when calculating the value in this way will vary depending on the security of the income. Sectors in which personal relationships are of paramount importance tend to use lower multipliers than asset- or technology-reliant businesses, for obvious reasons.

If you or your colleagues are an obviously key ingredient of the company's success, buyers may well offer a higher price if you are prepared to commit to staying on as an employee or consultant for a fixed period of time. This reduces disruption and smooths the transition to new owners. However, the buyers may offer to pay a second sum at the end of that period - a risky route if they already own companies that are not entirely solvent.

Whatever the sector, though, buyers tend to regard bigger businesses as more secure - they have greater resources with which to weather any unforeseen economic storms. Buyers will pay more for such reliability.

Businesses can have other advantages that will increase the security of their profits. For example, a business might have intellectual property rights over a particular manufacturing process, recipe or marketing logo; or it might have a contract with a major multinational or with the government.

Finally, the value of the business will also depend on the nature of the buyer. Acquirers will generally fall into two categories: financial and strategic.

A financial buyer, such as a venture capitalist, will generally look at your business in isolation, analyse the viability of its profits, and examine whether it could increase them if it were to streamline the company.

A strategic buyer, on the other hand, will be in the same or a related sector. Combining your business with his might enable him to cut costs in a way not possible for the financial buyer. He could centralize the sales and marketing function, for example. This type of buyer is also likely to have a greater understanding of - and faith in - the sector, and, consequently, your business model.

But while strategic buyers tend to be able to offer higher sums, they are few and far between.

Approaches from competitors are also dangerous. Do you really want to divulge the mechanics of your business to a potential buyer, only for him or her to abort the sale and remain a competitor? Then, he or she would be equipped with knowledge of your weak points, which he or she could then exploit, and your strengths, which he or she could then replicate?

One of the great advantages of knowing about valuation techniques is that it allows you to see what steps you can take to increase the value of your business - the subject of the next section of this guide from the team at BusinessesForSale.com

Ready to sell? You are just 10 minutes away from advertising your business to 1.3 million prospective buyers. Sell your business today.


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