Asset valuation: This is a good method to use if your business is stable and rich in assets, for example if you own property or machinery. In the simplest of terms, add up your assets and take away your liabilities, including adjustments for changes in value or old stock. However, this method takes no account of future earnings potential
Price earnings ratio: This is the value of the business divided by its profits after tax and is appropriate to use if the company has a sustained track record of profits. Multiply the business’ most recent profits after tax by the relevant PE ratio. Ratios vary widely and quoted companies will have a higher PE ratio than unquoted companies. You can get an idea of PE ratios from publications such as the Financial Times which give historic figures for different industries. A small unquoted business would normally be looking at a PE ration of between five and ten.
Entry cost valuation: You may want to start a new business from scratch and this method looks at what this process would cost – so elements such as product development, buying assets etc.
Discounted cash flow: For businesses who have invested heavily and are forecasting steady cash flow in the future, this is the most technical way to value a business. It is dependent on assumptions about long-term business conditions and is based on dividends forecasts and a residual value at the end of a certain period (at least 15 years).
Industry rules of thumb: This tends to be used in sectors where the buying and selling of businesses is very common. The formulas used vary but may include expected turnover, number of customers and outlets for that type of business. A lot depends on what the buyer feels the business is worth to them in terms of extra turnover/profit potential.
However there are also other intangible issues which cannot be measured in this way but are key to a business’s value: goodwill; intellectual property; or a strong management structure, for example. However, there are also risks. If your business is successful because of the people – and those people leave – or because of the excellent client portfolio – and you lose a part of that portfolio – and that gets damaged, then that is going to affect the value of your business. So make sure you ring fence your customer relationships and that your employee contracts are watertight.
Finally if you’re looking at buying a business, you need to work out its true profitability. Compare the profits stated by the owner to the audited figures and look for costs which you could reduce – on property and suppliers, for example. Look for areas to “restate” (to change a figure from one kind of cost to another) and, when looking at future profits, bear in mind the cost of achieving them.
Helen Reynolds is managing director of HB RIDA, a joint initiative between James Caan’s Hamilton Bradshaw Private Equity and The Recruitment Industry Development Agency. A business coach and entrepreneur, she provides support to fledging and established businesses.