What is your business worth?
When considering the value of the things we own, most of us have a reasonably good idea of what they are worth, at least for our major life investments, such as our homes or cars. Perhaps we have given into curiosity and looked at the recent house sales in the local estate agents, or asked for a quote from a second-hand car site. However, when thinking about the value of a company, arguably the most valuable asset many of us might ever own, very few of us know what it could be worth with any real certainty.
8th July 2022
Scott Hill See profile
There are many reasons why you might want, or need to know the value of your company. The most obvious would be that you are looking to sell, and therefore need to know a fair price to negotiate from. However, there are many other reasons you might need a valuation. HMRC would expect a valuation in a number of circumstances, such as if you were to decide to grant share options to long standing employees. Less happily, valuations are often needed for the sake of fairness and equity in probate or divorce proceedings.
Lastly, you might wish to obtain a valuation to track your company’s progress against its or your own your strategic goals. As your company is potentially a significant portion of your net worth, making sure that it will be able to realise the value you need to obtain the lifestyle you want in later life is critical for planning for the future. Likewise, if the company isn’t at where it needs to be, a valuation would give you the chance to speak to your advisers, and concentrate your efforts to grow and shape the business prior to sale.
Whilst it may be tempting to assume that value is value, and that any “accurate” valuation method should provide similar results, however in reality the valuation method chosen could lead to significantly different outcomes. For example, it is inefficient for trading companies to hold significant stock or cash in excess of their working capital need, as this would be better realised if re-invested to drive growth, or even invested externally to generate returns. As such, a net asset valuation of a trading company is likely to be significantly lower than its earning potential. Conversely, a property investment company is likely to have modest income compared to the value of the assets it owns, and in this case, a net asset valuation would be higher. It is therefore critical that an appropriate methodology is selected when considering your company.
Within the income-based methodologies, a discounted cash flow can be regarded as the ‘gold standard’ valuation method, at least in theory. This method calculates value based on ‘discounted’ future earnings, using forecasted information. Future income is discounted due to the ‘time value of money’, as it is better to have £1 now, rather than in a year’s time, due to factors such as inflation, and the fact that £1 now could be invested and earn returns, and hence be worth more than £1 in one year’s time.
In practice, private companies are not held to the same stringent accounting requirements as quoted companies, so forecasting future cash flows is not an easy task. Furthermore, calculating the ‘discount rate’, or how much less the future income is worth, also requires making a number of complex judgments, meaning wide ranges of rates from 10-25% are common. These factors mean that in practice this method is comparatively infrequently used.
Perhaps the most common method used to value private businesses would be the capitalised earnings method. This could be considered a ‘simplified’ discounted cash flow, as instead of trying to forecast future earnings, we instead use historical results to calculate a ‘maintainable earnings’ figure, on the basis that the company’s future income is likely to be related to its past performance. An investor is effectively purchasing the future income stream of the company, and might be willing to pay a certain multiple of yearly earnings to do so. Therefore, the value of the company can be thought of as its maintainable earnings, multiplied by an ‘earnings multiple’. This multiple commonly falls in the range of 3-8 times, and depends on the company, its performance, sector, and wider economic factors. Generally, smaller or riskier businesses would attract a low multiple, and large, stable or high growth companies would attract higher multiples, as investors are willing to take larger risks to obtain such companies.
Certain businesses, particularly professional services firms with recurring fees can be valued using a multiple of their turnover, although ultimately this is the same method as capitalised earnings, with the multiple being much smaller, which has the effect of assuming a certain net margin. Turnover can also be used to value start-up companies, as these may be loss making whilst they build their customer base. Valuation of start-ups is rather difficult, as most of their value early on is in ‘hope’ value, rather than an established customer base or brand.
When considering the value of a company’s assets, there is really only one method, Net Assets. All companies will disclose their net asset position as part of their annual financial statements, which does provide a starting point for the valuation, however due to the accounting rules used to create these financials, the net asset value disclosed is usually based on the historic costs of the company’s assets, and hence does not represent the current fair value of its assets and liabilities. Because of this, it is common to engage a panel of experts, such as chartered surveyors to provide formal valuations of key assets such as land or property, or specialist stock. These would then be used to update the net asset valuation of the company.