There is a universal truth in any market place that something of value is only worth what someone else is willing to pay for it on the day it is sold.
That rule of thumb rings true for establishing prices in business valuations, whether it is a business raising equity investment or being sold privately to another business, a business being sold publicly in an initial public offer (IPO), or shares being traded on a public stock exchange.
Truisms notwithstanding, there are various methods used to value businesses that SME owners and operators expecting to raise money or sell at some point in the future should be aware of. It is only by having an understanding of these methods that owners can hope to achieve the highest valuations for their businesses.
Equally, buyers of businesses also need to be able to discern where true value really lies and where there might be opportunities to discount the initial price.
Valuation Methods for SMEs
Firstly it is appropriate to point out that not all businesses are born equal so different valuation methods may be appropriate for different types of businesses. For example, manufacturing businesses are generally asset and capital intensive while service businesses are usually less so, meaning they require different approaches.
In addition, different factors are given different weight according to the size of the business – smaller businesses are generally considered higher risk. SME’s do not have a universal definition but for these purposes it is perhaps useful to consider them as businesses that fall approximately between £500,000 and £20m in turnover.
The valuation methods appropriate for SME businesses generally fall into a number of broad categories: asset-based valuation, present value models (discounted cash flows), and relative valuation (price multiples with market comparisons). It is important to note that these methods are not an exhaustive list and they are not exclusive in that they are often used simultaneously to gain greater insight into potential value.
Asset-based valuation may be a useful starting point for asset intensive businesses such as retail or manufacturing businesses. However, the value of a going concern should normally exceed the net asset value of a business otherwise the business can simply be bought and immediately liquidated to realise a profit.
Asset-based valuation is most appropriate for businesses whose assets form the bulk of their value such as property companies.
Present Value Models
In financial theory a business is worth today the present value of its estimated future cash flows discounted at an appropriate rate. This rate reflects the time value of money – a pound received today is worth more than a pound received tomorrow.
In normal English that means the cash flows of a business are estimated into the future before being discounted at a rate that takes into account issues such as interest rates, inflation and other risk factors. Theoretically the present value of those future cash flows added together is the present value of a business.
Clearly there is considerable scope for variability in the outcome of such a calculation, particularly for companies with volatile earnings or little historical data upon which to base assumptions.
In this method a price multiple is benchmarked using prices from publicly listed companies in the same sector or information on recent transactions involving similar businesses in a similar sector. Once a base price is established, discounts can be applied to take into account the specific risks of a particular company such as its size.
The best known price multiple is the P/E ratio (Price/Earnings) but there are others that are often used to get better comparisons between businesses. Price/EBITDA is a common example which considers earnings before elements such as interest and depreciation. This gives a better comparison by removing these variable factors.
The relative valuation method can also be useful for valuing high growth businesses that are yet to show profits through the Price/Sales ratio. Or it can be used with more unconventional inputs such as the Price/User ratio with businesses such as internet companies for example.
Business valuation can be a highly technical process, particularly for SMEs at the top end of the value range. Other less technical methods are also used such as industry rules of thumb but SMEs are always advised to seek an independent valuation before considering raising equity finance or contemplating a sale. For more information contact our business valuation expert, Grant Franklin