Article written by George Bradley – Friend Partnership Limited
Picture the scene. It is a Thursday evening. Peter Jones has just shot down an entrepreneur’s “ridiculous” valuation of their business. Whether you are going on Dragons Den, or are planning to sell your business, calculating a valuation can be a difficult and technical process.
Firstly, the business and its environment must be evaluated so that appropriate assumptions flow through into the valuation methods. This is done to help understand the business model, the type of assets held and the market the company operates in. For instance, a technology company which holds intellectual property will be much more difficult to value, especially if the technology is used in a niche market, when compared to a property investment company.
Before valuing a business, the underlying earnings will need to be calculated. This adjusts the profit made by the business to get a more accurate representation of the performance by eliminating exceptional items and non-recurring costs. Adjustments include adding in directors’ salaries if they are remunerated with dividends, as well as stripping out excessive overheads and other one-off costs that would skew the performance of the business. This exercise is also relevant if you were looking at purchasing a competitor, as the costs that could be saved can be stripped out.
The simplest method of valuing a company is by valuing the assets which are held by the company. This method is appropriate for simple businesses which hold most of their value in assets, for instance a company which solely owns investment properties or hold patents which could easily be sold on the open market. Here the individual assets are valued separately.
Comparable Company Analysis
When looking at larger, more complex companies a value can be estimated using comparable company analysis. This applies the average Price-to-Earnings ratio (P/E) of quoted competitors or the industry average to the underlying profit of a business to find the market value. A discount should be applied to the enterprise value to take account of public companies’ shares being more liquid than private companies, due to being traded in the open market.
A similar method can be used by making comparisons with the recent sales of similar companies. An average multiple ratio is calculated by comparing the business value of a recently sold company to the earnings they generated in the year of the sale. An average ratio is then calculated which is multiplied by the performance of the business being valued.
However, this method can be difficult if there is little merger and acquisition activity in the market, or the business operates in a niche market where there are no similar comparisons.
Discounted Cashflow Analysis
Discounted cashflow analysis is a technique that can be used to value a company of any size. Cashflows are prepared based on the underlying earnings forecast several years into the future. The cashflows are then discounted using an appropriate cost of capital to take account of the time value of money. The residual value is also calculated with an assumed growth rate. The growth rate should encompass the past performance of the business as well as the broader economic environment and average growth rates in the market the business operates in.
Which valuation method should a business owner choose when valuing their business?
As opposed to simply choosing one of the above methods of valuation, a combination of the methods should be used to get a more accurate estimate of the business value. Excess reserves of cash may be added to the valuation as these would be readily distributable to the owners of the business.
Valuing a business accurately in order to attract the right investors and obtaining favourable financing can be quite difficult. Here at Friend Partnership we have many years’ experience in valuing businesses and if you would like more information, help and advice, please contact us on 0121 633 2000 or by email to email@example.com.