Whether you are about to sell your business, looking to buy one or aiming to build your company into a retirement nest egg, knowing the value of the company is essential.

But how much is a business worth?

If one was able to perfectly see into the future, one could accurately project future cash flows, add them up and make an adjustment - because cash in the future is less valuable than cash in the hand today. But of course we cannot perfectly predict the future, therefore valuations differ because different people have different expectations.

Influence of ownership share on value

Your share of ownership will influence value.

If you are a minority shareholder you have less control over cash flows than if you are a significant or the majority shareholder. Consequently, your share of total ownership will influence valuation. This is a key reason why companies which are buying others that are traded on an open market such as the London Stock Exchange, pay a ‘Control Premium’ to acquire their target.

Capital structure and its influence on value

Intrinsically, a business laden with debt is less valuable than an equivalent one funded entirely with equity. This is because debt holders have a prior call on income (their interest charge) and the assets of the business, putting them ahead of shareholders.

Few businesses are funded either entirely with debt or completely with equity but the capital structure (ie the relative proportions of debt and equity) will influence value.

A business can be valued in a number of ways. Five methods are shown below:

Book Value, Replacement, Dividend Value, DCF, Comparative.

1. Book Value (or Balance Sheet Value)

This is the standard accounting treatment where assets and liabilities are calculated - the net amount of assets less the liabilities gives the Book Value.

This is simple, quick and available from published documents, even the much summarised and abbreviated accounts filed for small companies at Companies House.

The disadvantage of Book Value is that it tells nothing of the income that the business can earn.

2. Replacement cost

This is a modified form of Book Value by which assets are recorded at their replacement cost. This might reflect either asset price changes or the alternative that a buyer might have between setting up from scratch or when acquiring an existing business.

For example, the Book Value of assets in a factory is likely to be substantially written down by depreciation. If those assets are in good order and productive, the replacement cost may be a fairer valuation. Certainly, if you are running a business it makes sense to insure useful assets at their replacement cost.

Usually one would not expect liabilities to change in value but there are circumstances in which the replacement value of a liability would be either greater or less than its Book Value.

3. Dividend Valuation Model (DVM)

This is a useful method for valuing minority holdings in companies that pay regular dividends. DVM aims to value future dividends (ie, cash flows returned to shareholders) expected from the business and discounts these to their present value.

You will hear accountants, analysts and investment bankers talk about “risk free rate”, “equity risk premium” and “equity beta” but the essential elements calculating a valuation using DVM are to:

1. Estimate next year’s income (your dividend) - “d”

2. Estimate the growth rate in dividends - “g”

3. Determine an acceptable rate of return to meet your requirements “r”

The valuation = d / (r – g)

An example of this might be:

Next year’s dividend £100

Expected rate of growth 2%

Your required return 10%

Value = 100 / (10% - 2%) = £1,250

One can see that the result of a DVM calculation is very dependant on the estimates made, so different people may come up with very different values for the same business.

4. Discounted Cash Flow (DCF)

A business is worth the present value of its future cash flows. DCF attempts to project future cash flows and then multiplies them by a factor (the discount factor) to reduce them to today’s worth. The principle is very simple and you shouldn’t be blinded by jargon. The key element is to identify cash flows so you ignore, for example, depreciation but must include capital expenditure.

Below is a simple example using a discount factor of 10%, assuming cash flows happen at the end of each year and for a business over 3 years:

5. Comparative Valuation

Comparison is a very common way to value a business. This is not a complicated valuation - you will use comparative valuation regularly in your daily affairs.

Imagine that you are buying or selling a car. You look at a comparison website for your preferred make and model. The site gives you prices, shows a range of sources and probably compares it to alternative makes of car. When you buy or sell a property, you go through a similar process. Comparative valuation does the same for companies. It’s a little more complicated, because there are many more variables, but the principle is the same.

The more similar companies that you compare against, the closer you will get to a realistic valuation. You will need information on each company and your information may well be imperfect. The most commonly used comparative measure is Price Earnings Ratio, which simply expresses the value of a company as a multiple of its after-tax earnings. You can see these ratios in the Financial Times each day (heading P/E). Why is this the most common ratio? Because after-tax earnings are those attributable to shareholders and shareholders own the company.

Example:

You are looking to sell your business. Your most recent annual post-tax profit is £1 million and your corporate finance advisor identifies five comparable companies with the following P/E ratios: 6, 7.5, 8, 9 and 11. This gives us a range of values for your business as follows:

Low value 6.0 x £1 million = £6.0 million

Average value 8.3 x £1 million = £8.3 million

High value 11.0 x £1 million = £11.0 million

6. Other comparative ratios

In certain circumstances you will need to use different ratios. It may be appropriate, for example, to use Turnover or Gross Profit, Operating Profit or Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) to establish your valuation but, in each case, the key is to identify comparable companies from which to extrapolate your value.

If you or your adviser apply a multiple to an earnings statistic that is before interest charges, then this will give you an Enterprise Valuation (EV) and you will need to subtract debt from the EV to derive the equity value of your business.

Example:

Your EBITDA is £1 million and you have £2 million of bank debt finance. Your adviser establishes that the industry valuation standard is 3.5 X EBITDA.

From this you can derive your equity value as follows:

Enterprise value (EV) 3.5 x £1 million = £3.5 million

Less debt £2.0 million

Equity value = £1.5 million