How to calculate how much your business is worth

As a business owner, you will one day wonder how much your business is worth. There are many methods you can use to get an estimate, and the one you choose will be down to your business type, the industry you are working in and the reason for wanting a valuation. You will ultimately want to know the amount which does not sell yourself short or overstate what your business is actually worth. The main methods used for calculating how much your business is worth include price to earnings ratio, entry cost, valuing business assets, discounted cash flow, industry rules of thumb, value based on turnover and the ever-complex intangible assets. The intangible assets are the parts of your business that go above and beyond the standard net assets, such as a robust customer base, skilled staff, copyrights and other such valuable additions.

INTRODUCTION

For anyone buying, selling or simply running a business, knowing how much a company is worth and how it can be made more valuable is of vital importance. The valuation of a business will centre around how much profit a buyer can make, balanced against the accompanying risks involved.

Although past profitability and asset value will be the starting points, other intangible factors such as intellectual property and strong customer loyalty will carry a lot of value. In addition, no buyers will be put off if there is not a diverse client base. They will be looking to ensure that no single client accounts for more than 8% to 10% - if that client leaves, it will have a significant impact on the company's finances.

There are four main reasons you may want to ascertain how much a business is worth:

1. Help you buy or sell a business
2. Raise equity capital
3. Motivate management
4. Create an internal market for shares

Whatever your reason for calculating the value, it is a great way to identify areas for improvement and reduce your risk factors. This article will provide you with the basics for estimating your business's worth.

WHAT AFFECTS BUSINESS VALUATION?

Some areas of your business will be simpler to value than others – there are always a few intangible assets. It means that you will need to look beyond stock and fixed assets (like land and equipment). The following areas will also need to be assessed and have an estimated value attached:

• Business reputation
• Loyal and well-paying customers
• Business trademarks
• Circumstances surrounding the valuation (such as forced sale vs a voluntary one)
• Age of the business
• Strength of the existing team at the business
• Kind of product and services you offer

These intangible assets can make it tricky to reach an accurate valuation. However, there are some techniques you can use to make it a little simpler.

HOW TO CALCULATE YOUR BUSINESS VALUE

There are many different approaches to valuing a company. It is worth exploring them all as potential customers will want to know why the company is valued how it is. Each valuation process will also help highlight potential areas you may want to improve to make your business more successful.

Here are some of the main methods of calculating how much your business is worth:

• Price to earnings ratio (P/E) – Perhaps the most popular way to value a business, the P/E ratio (or multiples of profit) is the ratio of a company's share price to the company's earnings per share. It is best suited to businesses with a proven track record of profits. Figuring out the appropriate P/E ratio to use for your business can be determined by your profits. For example, if your company has a high forecast profit growth or a good record of recurring earnings, you will likely apply a higher P/E ratio. Due to ratios differing so much, there is no standard ratio. A good starting point is to use a four to ten P/E ratio for valuing a business.
• Entry cost – Luckily, this method is more straightforward than using a P/E ratio. Entry cost is simply the estimate of how much it would cost to set up a similar business to the one being valued. You will need to factor in everything that got your business to where it is today. This will include all the startup costs and tangible assets. For example, consider how much it costs to develop your products and services, build a solid customer base, and recruit and train staff. Once you have a figure, consider the savings that could be applied when setting up – such as relocating to a cheaper location using lower standard materials. Subtract that amount from the figure, and you then have your entry cost and valuation.
• Valuing business assets – If your business has established tangible assets, it is beneficial to evaluate the company based on the asset value. You will likely fall into this category if you are in property or manufacturing. Start by working out the Net Book Value (NBV) – these are the assets recorded in your company's accounts. Then move on to consider the economic reality of these assets and adjust the numbers according to what the assets are actually worth today. You should then deduct any debts which are unlikely to be paid off before the sale.
• Discounted cash flow – We now enter back into the complex way of valuing a business and rely on expectations of the company's future success. The discounted cash flow technique is best suited to mature companies with stable and predictable cash flows. It works by estimating what future cash flow would be worth today. To calculate the discounted cash flow, add the dividends forecast for the next 15 years (or more) plus a residual value at the end of the period. Next, you determine today's value of each future cash flow using a discount rate – accounting for the risk and time value of the money. The time value of money is centred around the notion that £1 today is worth more than £1 tomorrow due to its earning potential.
• Industry rules of thumb – There are some industries where buying and selling a business is common practice. These industries are likely to have some rules of thumb that can be used as a guide and base the value on factors other than profit. For example, this will likely apply to you if your business is in retail. The retail rules of thumb mean that your business may be valued by factors like business turnover, the average volume of customers and the number of outlets.
• Value based on turnover – This is the process of working out your business income over a set time period (like the tax year). Your turnover is the amount generated from total sales – be careful not to confuse this figure with profit (earnings after deducted expenses). Calculating your business turnover will help provide an insight into your business health. To go one step further, compare gross and net profit.

Remember that a business is only worth what someone is willing to pay for it. There could be a number of intangible assets which you believe value your business higher than what some of the other pricing methods provide. Highlight the intangible assets such as desirable relationships with customers or suppliers – they may be hugely desirable potential buyers too.

USING VALUATIONS TO BETTER YOUR COMPANY

As mentioned previously, you may want to go through the processes of valuing your business as a way to identify areas for improvement. Some of the main areas you may find require work includes:

• Better planning – Having a solid business plan with clear benchmarks will help you focus on what your long and short term goals are, along with how you plan to achieve them. This includes implementing or improving financial projections.
• Lowering risk – Many businesses get valued for less than the business owner wants due to the high-risk appetite. A great way to tackle this is to diversify your customer base.
• Streamlining processes – How you store information like financial records and day-to-day procedures will say a lot about how a business works. Put in processes that enable you to record as much essential information as possible to strengthen confidence in your business.

Once you have identified areas that are bringing down your business worth, you can allocate time and resources towards making improvements. If you are able to demonstrate stability, a diverse client base and tidy financial records, you will have a competitive advantage and increase the value of your business.

FINAL THOUGHTS

Whatever the value estimate of your business, it may be that your company is worth more to you than anyone else. After all, it was you that put blood, sweat and tears into building a successful company.

If you find yourself in the position where you want to sell your company, it is positive to know that many relatively small businesses can be high cash generative. Much of this success will be down to the owner's ability to manage and build a strong customer base successfully. Those who are experienced business purchasers will be aware of this – resulting in concern over the company's future viability without you at the helm.

As tempting as it may be to sell at the first opportunity, you can choose to keep running the business yourself to create a higher value base. Work towards mitigating the perceived purchase risk and ensure you do not have to sell yourself short.

FREQUENTLY ASKED QUESTIONS (FAQS)

What increases company value? There are two core steps you can take to increase the value of your business before selling. Firstly, increase your company's expected future cash flows – this will come from having a robust financial business plan. Secondly, reduce the level of perceived risk in your future cash flows. Higher projected growth and lower perceived risk will result in your business being worth more during the sale.

When should you sell a business? Business owners generally look to sell when they want to make a professional or lifestyle change or have received a purchase offer that is too good to turn down. It tends not to be a good idea to sell when your business is struggling – the value of your business will be based on how your market is performing at the time of sale. Aim to sell when business is good, not bad.

Where to list a business for sale? Before determining where to list your business for sale, the first decision is to choose whether to sell the business yourself or enlist the help of a business broker. Once you have selected the best route for you, the business can be listed in numerous places – such as online business listings, social media, local chamber of commerce and even local media outlets.

Do you pay tax when you sell a business? You may have to pay Capital Gains Tax in the UK if you make a profit (gain) when you sell all or part of a business asset. The business assets you may end up paying tax on include:

• Land and buildings
• Fixtures and fittings
• Plant and machinery (such as a digger)
• Shares
• Registered trademarks
• Business reputation

What is goodwill in a business sale? Goodwill is an intangible asset associated with the purchase of a company. It is the portion of the purchase price that exceeds the net assets included within the business sale. For example, goodwill may consist of the value of the company's brand name, existing loyal customer base, talented employees, supplier agreements and smooth-running processes.