The simple answer would be - what it might fetch on a sale between willing parties, ie what someone is prepared to pay for it, and the amount for which the owner is prepared to sell - but that wouldn’t make for a very interesting article!
It is a common misconception that a business is worth the value of its balance sheet. For profitable trading businesses, in fact the balance sheet figures normally represent the minimum value. The value of a business is generally much more than just the sum of its assets and liabilities.
So is there one correct way of valuing a business? The answer is that for trading ones, there are a number of ways, each of which should theoretically produce the same result. The key issue in determining what that value might be is the profits of the business, defined in a number of ways, including those below.
Earnings multiplier
The most common method used to estimate the value of a business is the ‘capitalised earnings’ method. The profits after tax are multiplied by an appropriate number of years purchase of profits known as the price earnings (PE). The greater the multiplier the better the market will tend to regard the business, including its growth prospects, and thus the greater its value. A private company might adopt a PE from a similar PLC, discount it, and apply it to its own profits. This would produce what is also called the enterprise value of the business, namely what the business is worth before deduction of any debt.
Other profit related valuation methods include application of a suitable multiple to EBIT – Earnings before interest, tax and depreciation – or EBITDA – Earnings before interest, tax, depreciation, and amortisation, usually of goodwill shown in the balance sheet. These methods focus on the basic profitability, and try to eliminate distortions caused by different financing costs, depreciation and tax rates.
Discounted value of future cashflows
Another method of valuing a business is to forecast the future cash inflows and outflows over a number of years. The total of the cashflows is then discounted for risk, delay, and other variables, to arrive at the net present value (NPV) of that future income. One problem with this method is that reliance has to be placed upon what are in fact unknown future income streams, which can be tricky.
Adjustments to profits
In order to calculate the true profits used in the above calculations it is important to analyse the profit and loss account and add back any costs that an efficient operator would not have. This could include excessive salaries to family members working in the business, or existing costs that the new owner of the business would not need – interest on bank loans, etc. There may also be some items of a one off nature, be they revenue or expenditure that could be removed from stated profits.
Assets
But many businesses own land, buildings and other tangible assets. How do they fit in? Whilst often not directly relevant to the overall business value, assets such as land and buildings help to define that very important asset called goodwill – the name and reputation of the business, enabling extra profits to be earned from the tangible assets. In valuation terms, goodwill is normally the capitalised earnings value less the tangible assets. Even in a business valued on its earnings, however, the existence of tangible assets is good, because if the business failed, at least the owners would be able to recoup some of their investment by selling them.
Why buy another business?
There may be many reasons for one company buying another. The term ‘synergy’ is often heard when businesses merge. “We won’t need two receptionists or two accounts departments” for example. Such savings could be one of the reasons that a buyer pays what might otherwise seem a high price. Quoted companies normally have higher PEs than unquoted ones. Therefore, if a quoted company buys a private one, and therefore its earnings, this increases the value of the quoted company.
Conclusion
But selling a business is about more than a particular valuation methodology. Just as people dress up to impress others, so a business needs to dress itself in the right way to attract buyers. What attracts buyers of businesses? - good profits, good accounting systems, good management, good cost control, as well as goodwill. The trick for the seller is to ensure that the business has all these in place before it comes on the market.
In order to achieve this, and as might be expected in any major financial transaction, it pays to take proper professional advice.
As featured in En Passant Magazine - April 2008.
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