Business Valuation Methods

The main valuation methods are:

  1. Earnings based
  2. Assets based
  3. Intrinsic Value based
  4. Industry Specific based

The Intrinsic Value based method in this software uses the Discounted Cash Flow technique.

The Industry Specific based methods currently included in the software include:

  1. Earnings before Interest, Tax, Depreciation, Amortisation and Owners’ remuneration. “EBITDA”
  2. Gross Recurring Fees/Revenue. “GRF”
  3. % Gross Margin

The software can produce a valuation for each of the above methods and for one of the given more common industry standard methods. The valuation that is produced uses the date that the user inputs and as such the resulting valuation relies in the accuracy of the data input and, in any event, can only ever be considered as a starting point for any negotiations.

Valuation Methods in detail

There are basically four methods of valuation:-

1) Earnings Basis

Most commercial valuations are based on the level of sustainable business profitability and an earnings multiple or rate of return.

The earnings basis method is an attempt to produce a Business Valuation of the sustainable profits of a business and is the recognised approach for valuing the majority of trading businesses on a going concern basis.

Although the starting point is often historical profits, these need to be adjusted for any exceptional items. For example, excessive director’s remuneration and pension costs, income and expenses relating to discontinued or new operations and the profit or loss on the sale of fixed assets. You also need to be careful to add back non-recurring costs such as bad debts, exceptional stock write downs, legal and professional costs. Adjustments should also be made to reflect the impact of any proposed changes in the future. Also, you need to look for areas in the expenses that need to be restated. For example, excessive or inappropriate depreciation charges, lower costs by utilising better purchasing power or economies of scale and increased borrowing costs, redundancy payments, etc.

The level of sustainable business profitability is normally calculated after allowing for these adjustments and after deducting tax.

We arrive at a commercial valuation by multiplying the sustainable business profitability by an earnings multiple. The usual approach is to apply an appropriate price earnings ratio. This reflects the rate of return that a buyer would require on his or her investment.

Private companies normally have a PE ratio of between 4 and 10 (although there are exceptions). This means that at the lower end sustainable business profits are multiplied by 4 and at the maximum end sustainable business profits are multiplied by 10.

Publicly quoted companies normally have a PE ratio of between 9 and 25 (although there are exceptions). This means that at the lower end sustainable business profits are multiplied by 9 and at the maximum end sustainable business profits are multiplied by 25. The reason why these are higher factors is because the shares are more marketable (i.e. more easy to buy and sell) and therefore more attractive to investors. Typically, the value of an unquoted business is half that of the comparable quoted business in the same industry.

Businesses with more stable sustainable profits generally have higher PE ratios. Also, businesses that are forecasting higher future profitability may mean that a higher PE ratio is more appropriate.

The value of any particular shareholding or percentage business interest will rarely represent a simple pro-rata proportion of the value of the business as a whole and as a result further adjustments will be required to the valuation to determine a guide price for minority interests.

2) Net Assets Basis

This method of valuing a business takes the individual assets and liabilities and adjusts them for their current market value. For example, the goodwill of a company or business is often ignored and this method of valuation would seek to place a value on goodwill. It is worth noting the fact that businesses are worth so much more than just the sum of the parts.

Normally, this method of valuation does not take into account the future profits of the business.

This method of valuation simply uses the net assets and liabilities on the company’s balance sheet and adjusts each asset/liability to reflect the current market values of the assets in the balance sheet. This method can also be adapted to include a valuation of the goodwill.

Goodwill is normally calculated as a multiple of sustainable profits after tax. The most common multiple factor is 3 years (although there are exceptions).

You need to adjust the book values as stated in the accounts to reflect current market value. Therefore, if the value of properties have gone up then include the current valuation, if there is stock obsolescence then reduce stock to its recoverable amount, if there is a huge bad debt lurking in trade debtors then reduce debtors to their recoverable amount.

Intangible assets, such as existing goodwill or development costs, should not normally be included.

This method of valuation is normally suitable for investment businesses and asset rich businesses. For example, a property letting business.

This method is not normally suitable for the valuation of trading businesses as a going concern.

This method may also be suitable for valuing businesses that are no longer going concerns. This may include businesses that have ceased trading, are in liquidation or is in a ‘forced sale’ situation.

3) Intrinsic Value Basis

This basis uses the discounted cash flows basis of valuing a business. It looks at the cash flows that are generated by a business as opposed to the profit it makes. Projections are prepared for say 5 to 15 years into the future in order to work out what the potential cash inflows are after tax for the period in question. A discount interest rate factor which reflects risk, inflation and debt/equity interest rates is then applied to the projected cash inflows and these are then aggregated with the residual continuing value of the company to give an overall valuation of the business.

This method of valuation is a very technical way of valuing a business and wholly depends upon a variety of assumptions that are expected to apply for a long period of time.

This method of valuation is more appropriate for cash-generating businesses that are strong and stable and which more often than not are mature.

4) Industry Specific Basis

In some industries, the buying and selling of businesses is very common and over time a number of industry specific yardsticks or rules of the thumb have developed.

Some industries have well established valuation methods, often based on a multiple of turnover. These include, for example, hotels, advertising agencies and professional services firms.

For example, the gross margin % for a telecommunications business, the EBITDA for a care home, the GRF for a professional service business.