FREQUENTLY ASKED QUESTIONS
One of my employees has built up a close relationship with many of our key customers, so to incentivise him to stay with the company for the long term I would like to offer him the opportunity to acquire shares in the business.
To do this I need an estimate of what the shares in the company are worth.
Can you give me some advice on how small companies are normally valued?
While there is a ready-made market and market price for the owners of listed public limited company shares, those needing a valuation for a private company need to be more creative. Various valuation methods have developed over the years. These can be used as a starting point and basis for negotiation when it comes to selling a business or valuing a company before selling or issuing new shares.
Earnings multiples are commonly used to value businesses with an established, profitable history. Often, a price earnings ratio is used, which represents the value of a business divided by its profits after tax. To obtain a valuation, this ratio is then multiplied by current profits. A difficulty with this method of valuation for private companies is establishing an appropriate price earnings ratio to use, as these vary widely. Price earnings ratios for quoted companies can be found in the financial press and one for a business in the same sector can be used as a general starting point. However, this needs to be discounted heavily as shares in quoted companies are much easier to buy and sell, making them more attractive to investors. A similar method uses EBITDA (earnings before interest, tax, depreciation and amortisation), a term which essentially defines the cash profits of a business and again an appropriate multiple is applied to this figure to arrive at a valuation.
For cash-generating, mature, stable businesses and those with good long-term prospects generally the Discounted Cashflow method of valuation is appropriate. This more technical method depends heavily on the assumptions made about long-term business conditions. Essentially, the valuation is based on a cash flow forecast for a number of years forward plus a residual business value. The current value is then calculated using a discount rate, so that the value of the business can be established in today’s terms.
The Asset Based valuation method is most suited to businesses with a significant amount of tangible assets, for example, a stable, asset rich property or manufacturing business. The method does not however take account of future earnings and is based on the sum of assets less liabilities. The starting point for the valuation is the assets per the accounts, which is then adjusted to reflect current market rates.
When buying and selling a business or valuing shares in some business sectors, certain industry-wide rules of thumb have developed. For example, when valuing an accountancy practice, the level of recurring fee income is often a key factor in determining the business value.
There are also a number of other important factors to be considered during the valuation process. Good growth potential is a key attribute of a valuable business and as such this is very attractive to potential buyers. Market conditions and how a business is adapting to these are important – buyers will see their initial investment realised more quickly in a growing business. External factors such as the state of the economy in general, as well as the particular market in which the business operates can also affect valuations.
Business valuations may need to consider the effect of intangible assets as these can be a significant factor and in many cases will not appear on a balance sheet, but are nevertheless fundamental to the value of the business. Consideration needs to be given to the strength of a brand or goodwill that may have developed, a licence held, the key people involved or the strength of customer relationships and how these affect the value of the company.
With any of the valuation methods, it is important to remember that valuing a business is not a precise science. In the end, any price established by the various methods will be a matter for negotiation and more than one method will be used in the process. Ultimately, when the time for a sale of shares arrives, a business is worth what someone is prepared to pay for it at that point in time.