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How is a small business valued?

Knowing how to value your business is essential if you are looking to sell it or raise capital. Buyers and investors will require an understanding of the current financial position, performance and expected performance of the business.

 

How can you calculate a business valuation?

There are many ways to calculate the value of a business. Before you undertake this work, it is important to get your financial records in to order and up to date. You may also want to invest in help from a financial expert or, if you wish to sell your business, a business broker.

Price to earnings ratio

One of the most common ways to value a business is to calculate the price/earnings ratio by comparing the company stock price to the earnings of the business. A high price to earnings ratio might indicate that the business’ stock is overvalued. Conversely, a low price to earnings ratio may suggest that the stock is undervalued. This is a helpful calculation for investors, but it is only relevant to companies which have already gone public. For smaller businesses that are still privately owned it isn’t possible to calculate this way. Therefore, we need to look at other possible business valuation metrics when calculating business value for small businesses.

Revenue

One of the simplest ways to value a business is to look at revenue. By looking at the total amount of money brought in by a company’s operations over a set period, e.g. over one financial year, and dividing that by the number of weeks, you can get a feel for the weekly revenue figures in order to understand sales performance. There are different ways to adjust this calculation to reflect the circumstances of your business, as we will see in the next few explanations. However, it is worth noting that valuing your business this way doesn’t tell you much about the profitability of your business, your costs, investments or assets.

Times revenue

For young companies that don’t have extensive financial histories on which to make calculations, it is possible to employ the times revenue approach. This multiplies the revenue of the business by an accepted multiple. For fast growing industries, this number will be higher than slow-growing sectors. This is a useful way to calculate business value for new businesses for which the potential for growth is higher. However, there is a degree of risk associated with this type of calculation because the selected rate of growth isn’t guaranteed. Nor does it consider the profitability, costs or assets of the business.


Discounted revenue

For more established businesses with a steady and predictable revenue, the discounted revenue method is a more appropriate calculation. It takes into account that £1 of revenue today is worth less than £1 in the future because of the effects of inflation on the time value of money. The discount interest rate will usually include a figure that represents risk, such as unexpected costs, so these can also be reflected in the calculation. This method of valuing a business is most often used when investors are seeking to calculate the attractiveness of investment in the business. It gives them a clearer idea of whether their investment can be paid back within the desired timeframe.

EBDITA

Earnings before interest, taxes, depreciation and amortisation (EBDITA) is one way to represent the cash profit generated by the company’s operations. By adding interest, taxes, depreciation, and amortization back to net income, EBITDA is useful when comparing the underlying profitability of companies regardless of their depreciation assumptions or financing choices.

Because amortisation is often used to expense the cost of software development or other intellectual property, early-stage technology and research companies often use EBITDA when talking about their performance. However, others argue EBDITA is not a meaningful measure of corporate performance because it omits depreciation and capital costs.

 

Net book value

Looking at revenue isn’t the only way to value a business, however. For asset-rich businesses, an asset valuation based on net book value (NBV) can offer a good understanding of the value of the business. NBV is calculated by first adding up the total value of the assets held by the business. When calculating the value of your assets, you should consider both tangible assets, such as land, premises, stock and equipment, and intangible assets, such as intellectual property (IP) and brand assets. Once you have arrived at an asset value, you then subtract the costs of business liabilities, such as debt and outstanding credit to arrive at the NBV figure. For this method to be useful, you will need to keep your asset records up to date, so that their value reflects inflation, depreciation and appreciation. It is most useful when used alongside other valuation methods.

 

Entry valuation

Another method of calculating a business valuation for a small business which takes into account the assets of the business is the entry valuation method. It is calculated based on what it would cost to establish an equivalent business from scratch. These startup costs, including asset purchase or hire, staff recruitment and payroll, marketing, etc, offer an understanding of the business at a given point of time, but don’t reflect the future value of the business or its profitability. However, it can be useful for niche businesses or new startups without a significant history of revenue to use entry valuation to understand business value. It’s also a useful tool in competitive analysis because, by using this type of calculation, you will get a good understanding of the costs and barriers to entry that new competitors would face.

 

Comparable analysis

For businesses that aren’t in niche sectors, a comparable analysis is a much easier way to calculate a business valuation. By assessing the value of businesses similar to yours, you can arrive at an understanding of the comparable value of your business. While this method is popular, it doesn’t illuminate the specifics of your business for investors and, therefore, is of limited usefulness.

 

How is a small business valued?

As we’ve seen, there are many ways to value a small business. 

Using a combination of methods is the best approach to get a true understanding of the value of your business, especially if there are characteristics of your business which lend it value that are not necessarily reflected in business calculation methods based solely on revenue. 

For example, if you operate in a niche market with expensive barriers to entry, the entry valuation used alongside a revenue valuation will give investors a better understanding of the value of your business than a revenue valuation alone. Alternatively, if your business holds a lot of assets, you would be best served to use the NBV method alongside a revenue method.

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