A small group of people are in what looks like a living looking and smiling at a laptop on a table

There may come a time in the lifespan of your business that you need to seek a valuation. It's not one of those things that every business owner will have to do at some point, but it's definitely a topic that's worth demystifying in case you should ever find yourself in certain circumstances.

With that in mind, let's first take a look at some of the reasons why a business valuation might be called for:

  • Negotiations between directors and shareholders
    If shares are being transferred between shareholders and/or directors then their value needs to be established.
  • Buy out negotiations
    If a management buy out (MBO) is underway, then a valuation will set the a price that the management team can then assess ways to finance.
  • Securing investment and funding
    Investors want to know where they're putting their money and what they can expect in return, so a valuation helps demonstrate where you're at. The same goes for funding applications.
  • Tax reasons
    An objective, independent report on the value of your business is sometimes needed when dealing with HMRC on tax matters.
  • Financial future planning
    A less corporate reason, this, but having your business valued can help you plan a viable retirement date, as well as letting you see how much you need to invest between now and then to make it happen. (If  you aren't sure about different finance jargon that you may have come across, then take a look at our 8 most common business finance terms explained.)
  • Family disputes
    The business may sometimes have to be valued to form part of an overall evaluation of your estate. You might not be around to need it, but it will help the family.

That's most common reasons for getting your business valued covered, so the next question is how do you actually go about establishing the its worth? Well, there's actually a few ways to to do it.

A man is using woodwork tool to build a wooden object

Price to earnings ratio (P/E)

If your business has an established track record of making profit over the years, then there's a chance it's best suited to a price to earnings ratio (P/E) valuation. Your P/E ration is established by a high-growth forecast, or by strong repeat earnings.

Unfortunately, P/E ratios are subjective, and can differ drastically between businesses. For example, a reasonably tech start up that is a high-growth company will have a high P/E ratio, while businesses that have been established longer and have made a more steady profit over the years will have a lower P/E ratio. There's no standard as such when it comes to P/E, which makes it tricky to pin down.

Asset valuing

If your business has been trading for a while and has lots of assets (property, equipment, etc.) then it's often worth choosing to be valued based on their value.

Your accounts will be able to tell you how much you paid for equipment or buildings, but it's always worth considering whether they have gone up or down in value since purchase and adjusting your figures as necessary.

Discounted cash flow

This one is quite a bit more complex. The basic theory is that owners of long-running businesses with stable cash flows can estimate what its future cash flow would be worth today. The valuation comes by adding dividends forecast for a set time period (say the next 15+ years) and a residual value at the end of that time.

Still following? The next thing to do is to calculate the value of the future cash flow using a discount rate of between 15 to 25 per cent, which accounts for the risk and time value of the money on the premise that it would have greater earning potential if you had it today.

Once you've done this for each of the years in your time frame, you'll be able to arrive at a predictive estimate of the business' value.

Phew.

(For more help on using your cashflow statements for decision making, check out our article all about it, here.)

A woman is standing smiling behind a till inside a restaurant

Entry cost

Back to more concrete figures, the entry cost is simply how much it would take to set up a similar business to the one under valuation.

All you have to do is add up all of the expenditure that it's taken to get the business to where it's at (start-up costs, overheads, etc.) and the cost of any assets and wages. The next step is to evaluate where you could have possibly made a saving using different suppliers, materials, or even setting up in a different location. Once you have that figure, subtract it from the set-up and running costs to arrive at an entry cost valuation.

Industry standards

Some industries have certain standards, rules of thumb if you like, that allow businesses to be valued more quickly and easily.

Retail businesses are bought and sold more regularly than, say, a painting and decorating company, so they have a set of criteria that they look at that doesn't necessarily include profit. The likes of average customer numbers, location, footfall, number of outlets, and turnover are all important when it comes to valuing a retail operation, and so it's possible that other industries will have their own short hand criteria for valuations.

Unmeasurables

Lastly, but not leastly, there are certain elements that add value to a business without being particularly measurable.

These can include a strong brand, a loyal management team, excellent relationships with existing customers, top-class assets – anything that makes the company more desirable to a potential buyer really.

For more information on business finance and funding, you can find our full collection of free resources, here.


Download your Ultimate Guide to Starting a Business now, for free!