Business Valuation Methods

The true value of a business is what someone will pay for it. To arrive at this figure, buyers use the following valuation methods:

Asset Valuation: This method is appropriate if the business has significant tangible assets (i.e. it’s a property business). Please see more details at the following link: 

Price/earnings ratio: A method appropriate if the business is making sustainable profits. Please see more details at the following link:

Entry cost: Rather than buy a business, you could start a similar venture from scratch. An entry cost valuation reflects what this process would cost. To make an entry cost valuation, calculate the cost to the business of: Raising the necessary financing, purchasing its assets, developing its products, recruiting and training the employees, building up a customer base). Then make a comparative assessment. Factor in any cost savings you could make (i.e. by using better technology, by locating in a less expensive area, etc.). The entry cost valuation can then be based on cheaper alternatives, which is generally more realistic.

Discounted cash-flow: This method is the most technical way of valuing a business. It depends heavily upon assumptions about long-term business conditions. It is used for cash-generating businesses which are stable and mature. The valuation is based on the sum of the dividends forecast for each of the next 15 years (at least), plus a residual value at the end of the period (the value today of each future dividend is calculated using a ‘discount interest rate’, which takes account of the risk and the time value of money – $1 received today is worth more than $1 received tomorrow). If a business can inspire confidence in its long-term prospects, then this method underlines the business’ solid credentials.

Industry rules of thumb: In some industry sectors, buying and selling businesses is common. This leads to the development of industry-wide rules of thumb. The rules of thumb are dependent on factors other than profit. For example: Sales turnover, number of customers, number of outlets, etc.). Furthermore, buyers will work out what the business is worth to them.

When valuing a business, you usually use at least two of these methods to arrive at a range of values.

A small unquoted business is usually valued at between five and ten times its annual post-tax profit (previously - most notably in the IT market - the ratio has exploded, with some valuations being drawn from multiples of 70 or more, however, the differential has closed significantly, with IT-based companies seeing the sharpest drops).

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