In the understandably subjective world of business valuation, there are several traditional methods which are used for establishing the value of a company, based mainly on financial data.
Ultimately, in the case of small companies, the value may be influenced more by what a prospective buyer is willing to pay (and the seller to accept), than conventional valuation techniques which may be more suited to larger businesses.
You should also read our recent article, key considerations when valuing a business, which looks at the intangible factors which come into play during the valuation process – such as the prevailing economic climate, the reasons for sale, and many more.
There is no ‘one size fits all’ formula for valuing a business, as no two businesses are the same, but here are some of the most commonly used methods:
Multiples of Earnings
This is a commonly used method of valuation, particularly for larger companies (such as stock market quoted businesses).
The Price/Earnings (P/E) ratio varies according to the type of industry the company is in. For larger companies, the ratio will be higher than for smaller companies – even as high as 30 for some high-tech quoted companies.
The ratio will vary depending on the type of business in question, and the profitability of the sector.
As small companies are harder to buy and sell (unlike stock market quoted ones), the P/E ratio for a small company in any given sector, may be less than half that of a larger, established business.
Few small companies are bought and sold on the basis of P/E ratios.
This type of valuation is typically used for established, cash-generating businesses, and is based on predictions of the company’s future profitability. The value is calculated using the total sum of expected dividend declarations over the next 10,15,20+ years, and a ‘terminal value’ at the end of that term.
Again, this type of valuation will not be appropriate for most smaller companies
Another valuation method used for more established businesses with significant tangible assets, asset valuation is simply how much all the assets would be worth if they were sold (to put it very simply). Firstly, you establish the net book value of all the assets owned by the business, then you factor in other things such as the realistic sale value of certain assets in the current market, regardless of their ‘worth’ in the accounts.
This is a simple method of valuation, which may be suitable for valuing some small companies. It calculates the cost of reproducing the company from scratch, including everything from building up a customer base, creating a brand, building a team, and developing new products and services.
In some industries, there are ‘rules of thumb’ which have traditionally governed the value of companies in the sector. This is often the case in the accountancy, financial services, and property industries, for example. They take into account the typically profitability of companies in the industry, including any liabilities a new owner would have to take on.
Real World Valuations
Although many of these valuation methods may be useful for larger, established companies, they may have limited use when valuing smaller companies, for many reasons.
Ultimately, the company is only ‘worth’ what a buyer is willing to pay. This will be influenced by many factors, including the current economic climate, how many competitors there are, how many potential buyers there are, the makeup of the current management team, and the makeup of the company’s customer base.
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