Business Advice

How to value a business

Cameron Fleming | 22 April 2021 | 3 years ago

How to value a business

How do I calculate the value of my business?

This year might be a turning point in your life as it has been with many entrepreneurs.  On your priority To-Do list might be: Sell the business, Buy yacht, Retire. To help you along the way, here are a number of methodologies to determine your business’s value and take a longer-term look at evaluating a business. Working towards a greater value will certainly ensure you have a better size cabin on that wanderlust yacht.

Option one – Value of assets calculation takes the combined value of everything the business owns and then has debts or liabilities subtracted from it. You could start with the balance sheet value, but the business is usually worth more than its assets.

Option two – Revenue-based evaluations require you to take your annual sales figure to a stockbroker or business broker for them to use that benchmark to compare to the worth of typical businesses in your industry. In some instances, it is two times the sales amount.

Option three – Earnings multiples is a more relevant measure. Also called the price-to-earnings (P/E) ratio. Forward project the expected earnings of the company for a few years. Projected earnings of £200 thousand / annum multiplied by a P/E ratio of 15 gives a value of £3 million.

Option four – Discounted cash flow (DCF) is a complex calculation that takes the annual cash flow, projects it forward, and then discounts the future cash flow value to today. You can use the Dept of Finance online NPV calculator.

Option five – It may be appropriate to base the assessment of the value on more than accounting. Do you have a ‘hot’ location? If somebody wants to buy it, does your business have strategic value via business synergies?

Let’s look at the 3 most popular business calculation methods in more detail.

What are the 3 ways to value a company?

There are factors that influence ALL potential business buyers, investors or partners. The top are return-on-investment (ROI) and relative risk. The latter can be mitigated VERY effectively via these factors:

  • Your new sales have quantifiable, predictable key drivers
  • Your foot/online traffic source is not niche, is stable and IS growing.
  • Your supply network is solid and has established backup options.
  • Loads of repeat sales AND repeat customers
  • No legal shenanigans in the business history
  • Good systems and processes, all documented
So you have ticked all the above boxes, let’s look at the 3 top ways to value a company:

Valuation method 1: The interested buyer will use an Earnings Multiple of 1-3 (business size dependent) and apply it to annual profits. If using monthly statistics, the multiple factors might be 12-36. For very LARGE, booming businesses, the 12-36 factor might be applied to annual profits, but not for the average business valued under £3.5 million.

Valuation method 2: Your sales data might undergo Comparable Sales analysis against similar businesses. This might not be scientific but does give the buyer a ballpark idea.

Valuation method 3: Assets such as traffic size and quality, mailing list size and quality, domain name quality, brand market penetration, and other value-leveraging factors will be used in an Asset valuation methodology.  A buyer looks at value-leveraging for bigger profits and quick R.O.I. when a business is making little to no profit.

What are the ways I can sell my business?

There are 3 main routes that you can approach for putting your business ‘on the market’:

  1. Broker (£180k – £3.6m in profit) – Medium-sized businesses are best sold through brokers who help with selling your company. Best for businesses making between $250, 000 and $5m in profit per year.
  2. Marketplaces (<£250k profit) – Businesses of this size do well when sold through forums or marketplace websites privately by the owner.
  3. Investment Banks (>£3.6m and over profit) – This business is categorised as large.  It is prudent to sell that size business through investment banks or merger/acquisition specialists.
Now you have chosen your route for selling, is there a ‘quick’ valuation you can do before meeting a broker, bank, buyer or investor?

How do you value a business quickly?

One fact that counters any evaluation is that if there isn’t a buyer available who will pay the business price tag, then, in reality, it isn’t worth the evaluated price.

Everything is only ever worth what someone is willing to pay for it.

However, valuations for loans or security can only be tested against historically similar transactions (comparable evidence). Valuations are also ONLY the point of departure for negotiations.

Hopefully, you have progressively built your business with selling in mind. You would have predicted this event when you captured your exit strategy in the original business plan.  Preparing for it and regular assessing company strength maximises potential when selling.

If you are using a business broker, they tend to focus on two areas of valuation: EBITDA Multiple and Asset Value.

1) EBITDA Multiple – This stands for “Earnings Before Interest Tax Depreciation and Amortisation” and uses the operating profit or net profit before any tax or interest deductions.  Balance sheet assets are used to represent their annual cost based on its perceived operating life, e.g. a laser cutting machine purchased for £25, 000 with a 5-year lifespan will be charged to the balance sheet at £5, 000 per year. Note: one-off and exceptional costs must be added back into EBITDA.

The valuation uses the EBITDA multiplied by a factor. There is a wide range of multiples used in valuations, but for SMME, the factors of 1-3 are prevalent.

2) Asset Value – If the assets out-value the EBITDA multiplied sum, then don’t use the latter. Use the asset value. A limited company needs to reconstitute its balance sheet with up to date market values of fixed assets instead of the artificial depreciated value.

A sole trader or partnership must only have knowledge of asset values (which must be free from any encumbrance). You can look online for evaluations of similar assets. A small premium for the business being in situ and trading might be obtainable. A broker’s advice would be highly advantageous.

To keep your company strong, your regular assessments of it should include objective profit assessments. This brings you to the question of the correctness of what you are charging.

Are you charging enough to clients?

How did you originally calculate the cost price of your product? Have you calculated your wholesale price and retail price?  What do you include in your cost price calculation?

It is often impossible to cost in ALL the operational costs plus marketing and equipment.  As an example, let’s use a small manufacturer to assess how they should cost their business.

Factor #1: Overheads

These need to be paid regardless of zero sales or being closed for the holidays, e.g. rent, phone, car repayments, insurance, marketing, business rates, utilities and extrapolated equipment costs. This figure, for now, excludes your drawings/salary or raw materials.

With no paid costs yet, for a brand new business, research what the actual overhead costs would be.

Next, ascertain how many hours per year are spent on making products that can be sold – the hours that generate income. This EXCLUDES marketing, admin, meetings etc.

In your first years, aim to spend around 40 per cent of your time physically making saleable products.

If up to 80 per cent of your time is spent “making”, then you don’t have a sustainable business.  Another 40 per cent of time should be spent on marketing to the sales you need. 10 per cent should be spent on professional development and research and 10 per cent on administration.

An established maker can ‘up’ the time spent on making to around 50 per cent. Their established reputation requires a little less marketing.

If you use 4 weeks for holidays, illness, other and work 40 hours/week, the total annual hours “making” would be: 48 weeks x 40 hours x 40 per cent = 768h/year.

If your overhead costs were £12, 000, then divide it by 768 hours = £15.62 per hour.

Now you can see why overheads MUST be as low as possible.

Factor #2: Earnings

How much do you want to earn, or how much do you think the future owner would want to earn?

Living expenses, rent or mortgage, council taxes, food, clothing, gifts, school fees, medical fees, holidays, and the list goes on. Keep it realistic, though. Let’s use an example of £22, 000/annum before national insurance, tax , deductions etc.

The salary will be taxed if it is >£10, 000 of profit from the business. Click here for details of the personal tax allowance.

As a start-up, you would aim to draw the absolute minimum from the company, so slashing back on personal costs is crucial. Using 768 hours obtained in Factor #1, an hourly wage requirement = £22, 000/768h = £28.65/hour

Factor # 3: Total hourly rate

This means you simply take your hourly overhead costs and add on the hourly wage. Using the figures, we have calculated thus far: £15.62 + £28.65 = £44.27

Factor # 4: Making time per one product

This sounds easy but can be tricky. “Guesstimating” is not recommended. Create a timesheet and log in your start and stop times. Entrepreneurs’ guesses are frequently far off from reality.

Obviously, your production processes and approach must maximise efficiencies and effectiveness, e.g. combine various orders together, produce small batches at a time, set aside non-making activities and don’t allow yourself to be interrupted.

Include all production processes such as set up, cutting, mixing, pouring, sewing, finishing, packaging etc.

By doing small batches, you will get a good indicative average production time, e.g. cutting 6 hats or creating 6 bowls in 2 hours gives you 20 mins making time per item on average.

But if, for example, you took 2.25 hours to make one item: 2.25 hours x £44.27 (hourly rate) = £99.60 per product.

Another valuable exercise to work through for costing the value of your products (and therefore your sales and business) is to do a ‘reverse’ calculation. This starts with taking 40 per cent of a 40-hour workweek = 16 hours. 16h/2.25h(per product) = 7 products per week.

Can you produce 7 items a week? Or do you need to look at producing more by addressing processes and procedures?

Factor #5: Total material costs

The pricing calculation is still not finished.  All the material costs to produce one item need to be added on.  But how? If, for example, you are using £22.00 worth of materials per item, this would need to include ALL materials, including release agents for bowl moulds, threads for sewing, etc. All the material costs and the receipts should be carefully recorded, even the tiny ones.

Of course, slashing costs might involve using more affordable materials, but it is seldom prudent to use the cheapest materials. If, for example, you use a cheap releasing agent, it might damage the bowl on each release and require more finishing (expensive labour cost), or a cheap zip in a pullover might break. The damages to your brand require reverse logistics (expensive) and require a new zip to be put in. That is, ultimately, a very expensive zip.

A person interested in buying your company will not be impressed if they see a lot of product returns or complaints online.

Factor #6: Contingency ‘fat’.

Generally, a contingency percentage factor of about 10 per cent is used by companies, depending on their product, the location of their market and the price of their product. An expensive product might have a lower percentage, or if you are shipping into a country like Nigeria, the global norm for that location is a contingency factor of up to 100%.

A contingency factor gives you room for human error, unforeseen extras and gives you room to offer discounts or special offers. It also allows you to offer payment terms, e.g. 50% upfront and 50% once shipped. This is where the 100% contingency factor is often used.

We are using 10% for this example, which is represented as 110 per cent in a pricing calculation or 1.10.

Factor #7: Total cost price

At this stage, you will have done a lot of research and should be fairly confident that you have covered ALL the bases. Now the final calculations:

£99.60 (making time – Factor #4)

+£22.00 (material costs – Factor #5)

= £121.60

x 1.10 (10 per cent contingency – Factor #6)

= £133.76

And there is the price of your product.

Now you need to ascertain if you are selling your products at the right price, which will make your company more profitable and more attractive to a potential buyer now or in the future. The interested buyer will find your thoroughly thought through pricing to be reassuring that they are buying a business with solid business acumen applied to it.

Finally, all you need to do now is find the right yacht!

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