How to value a business

Posted: 15 / 05 / 2017

The value of private companies is often gauged using one of a number of methods.

Earnings based calculation

The first and probably most common method is an earnings based calculation (i.e. a multiple of maintainable profitability). This is on the basis that it is the business’ earnings that will determine the financial return from an investment.

Earnings may not be taken directly from the accounts as there are a number of adjustments which may be applied to identify the maintainable profits.

The P/E (price/earnings ratio) will depend on the company, the industry and the wider economy as a whole. By way of example, a company in a traditional industry such as print may expect a P/E of around 3 or 4 times whilst a business in a more dynamic sector such as online or technology may expect to achieve a multiple of around 8 to 10 times profit.

Assets

Another common method, usually applicable to distressed companies or those without profits, is the asset based method.

This basically applies a value to each of the balance sheet categories taking into account any costs associated with realising the value attributed to each, this may be applied to highly capital intensive businesses such as farming or manufacturing.

A mix of the two

To complicate it further, some deals actually include an amalgamation of the above two methods, with a business being valued at net assets plus a perhaps slightly lower multiple of the maintainable earnings.

Turnover or gross profit multiples

Certain industries, including those in the financial services sector or telecoms, are valued not on a multiple of profits but upon turnover or gross profit multiples. For example, in the Telecoms sector a business is often valued at a multiple of gross profit, typically 2.5 years GP can be achieved depending upon the mix of services and lengths of contracts.

A financial based service business, like an accountancy firm, would expect to achieve a value based upon revenues expected to be between 0.8 and 1.4 of annual turnover dependent upon the quality of the clients acquired.

Other methods

The above bases for valuation are by far the most common, although other methods exist including the following:

Discounted cash flow method applies a present value to future free cash flows by applying discounts based on a number of calculated assumptions and formulae.

Corporate valuations can also be derived from the dividend income model which is more applicable to listed entities whereby a historic pattern of dividend policy can be analysed.