Price/earnings ratio

This business valuation method is appropriate if the business is making sustainable profits. The price/earnings ratio (P/E ratio) is the value of a business divided by its profits after tax. P/E ratios are used to value businesses with an established, profitable history.

Quoted companies generally have a higher P/E ratio. A typical P/E ratio for large, growing quoted companies with excellent prospects might be up to 20. Their shares are much easier to buy and sell. This makes them more attractive to investors than shares in comparable unquoted businesses.

Typically, the P/E ratio of a small, unquoted company is 50 per cent lower than that of a comparable quoted company in the same sector.

Compare your business with others.

What are your quoted competitors’ P/E ratios?
What price have similar businesses been sold for?
P/E ratios are weighted by commercial conditions.
Higher forecast profit growth means a higher P/E ratio.
Businesses with repeat earnings are safer investments, they are awarded higher P/Es.
Adjust the post-tax profit figure to give a true sustainable picture.

How to calculate profit:

If you are considering buying a business, work out what the ‘true’ profitability is.
Compare the owner’s stated profits with the audited figures (question any differences).
Look for costs which could be reduced under your ownership (i.e. unnecessary property leases, supplies, over-lapping overheads, etc.)
Look for areas to ‘restate’ (an accountancy term for changing a figure from one kind of cost to another). Use your own accounting policies when calculating the business’ profits. This will often result in a significantly different profit figure.
When looking at future profits, bear in mind the costs of achieving them (i.e. servicing increased borrowings, depreciation of investment in plant, machinery, or new technology, redundancy payments, etc.).

Take also into account that the arrival of new management often leads to major changes which may mean higher costs and lower productivity in the first year.

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