The two questions: ‘How much is a business worth?’ and ‘How can I make it more valuable?’ are of paramount importance to any business owner looking to buy, sell or to build a profitable business but to answer these questions depends on a number of factors.
Essentially, the worth of a business depends on how much profit someone can make from it, balanced by the risks involved. But past profitability and asset values are only the starting points. It is often intangible factors, such as key customers, which provide the most value.
Factors affecting business value
Ultimately, the true value of your business is what someone will pay for it. To arrive at this figure, buyers will use various calculations.
If your business has tangible assets, such as property or machinery, then adding up your assets and taking away liabilities is one way to calculate its worth. This is a good technique if the business is asset rich. However, it doesn't take into account future earnings.
Price/earnings (P/E) ratio is the value of a business divided by its profits after tax and is used to price businesses with an established, profitable history. If you're looking to buy, the way to work out the 'true' post-tax profitability of a company is to look at costs that can be reduced such as consultancy fees, suppliers and overlapping overheads. Higher forecast growth means a higher P/E ratio and businesses with repeat earnings are safer investments so they are generally awarded higher ratios.
If you're looking to start a new venture rather than buy an existing one, then a good way to look at the value is to work out the cost to raise the necessary finance, to purchase assets, to develop products, to recruit and train employees and to build up a customer base. Then factor in any cost savings you could make such as by using better technology or locating in a less expensive area. This will bring you to the entry cost valuation for the business.
Discounted cash-flow is best for valuing stable and mature cash-generating business that has invested heavily and is forecasting steady cash flow. The valuation is based on the total sum of the dividends forecast for a projected period plus a residual value at the end.
What can affect the valuation?
A forced sale can drive down the value of a business. For example, if an owner-manager has to retire because of ill-health, or if you are winding up the business then its value is likely to be the sum of its realisable assets (i.e. assets which can be sold easily) less its liabilities. Forced sales tend not to take account of any additional value attributable to ongoing revenue or profit.
How tangible are the business assets is also an influencing factor, as is the age of the company. Many businesses have almost no tangible assets beyond office equipment so the main thing you are valuing is future profitability. If it's a young company then it may have a negative net asset value, but may still be valuable because of its potential, long-term financial return.
Often, the key source of value to a business is something that can't be measured - the intangible assets. Strong relationships with key customers or suppliers and management stability are just some of the things that can affect how much a buyer is willing to pay.
Why value a business?
There are four main reasons. One is to help you to buy or sell a company. There's a better chance of a sale being completed if both parties have realistic expectations as to the value of the business.
It's also a way to raise equity capital and to create an internal market for shares. A valuation can help you agree a price for the new shares being issued to raise funds and to help you to buy and sell shares in a company at a fair price. It may be necessary to undertake a formal valuation exercise when new shares are issued if you are using a tax efficient scheme like Enterprise Management Incentive (EMI).
Another good reason is to motivate management. Regular valuation is a good discipline as it provides a measurement and incentive for performance, especially if the management are part owners. It can help to identify areas of the business that need transforming and to focus management on the important issues to bring about change.
At the end of the day, if a buyer will only pay what they think a company is worth then, whether you're buying or selling, look at all the factors that can influence the value to decide if it's worth a sale.
By Emma Ladd, Senior Associate at Gardner Leader solicitors