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Valuing a Business
3. Valuation Techniques
Remember that the true value of a business is what someone will pay for it. To arrive at this figure, buyers use various valuation methods.
The main valuation methods are based on:
3.1 Assets (see 4).
- This method is appropriate if your business has significant tangible assets. For example, a property business.
3.2 Price/earnings ratio (see 5).
- This method is appropriate if the business is making sustainable profits.
3.3 Entry cost (see 6).
- This method values a business by reference to the cost of starting up a similar business from scratch.
3.4 Discounted cashflow (see 7).
- This calculation is based on future cashflow. It is appropriate for businesses which have invested heavily and are forecasting steady cashflow over many years.
3.5 Industry rules of thumb (see 8).
- This method uses an established, standard formula for the particular sector.
How to Calculate Profit
If you are considering buying a business, work out what the 'true' profitability is.
Compare the owner's stated profits with the audited figures.
- Question any differences.
Look for costs which could be reduced under your ownership.
For example:
- Consultancy fees.
- Payments to the owner and to other shareholders.
- Unnecessary property leases.
- Supplies - is there a cheaper supplier?
- Overlapping overheads.
Look for areas to 'restate' (the accountancy term for changing a figure from one kind of cost to another).
For example, money spent on software development may have been capitalised by the owner. You might consider that it should have been treated as a cost.
- Use your own accounting policies when calculating the business' profits.
This will often result in a significantly different profit figure.
When looking at future profits, bear in mind the costs of achieving them.
These may include:
- Servicing increased borrowings.
- Depreciation of investment in plant, machinery, or new technology.
- Redundancy payments.
The arrival of new management often leads to major changes which may mean higher costs and lower productivity in the first year.
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