Expert guide: Valuing a company

By Adrian Ward, director, AMS Business Sales

The question of how to value a business is one which pops up frequently on Accountingweb. In truth, a business is only worth what someone will pay for it. The price paid on the day of sale is the only time that a company value is not a matter of opinion or conjecture.

It is useful to meet two or three experienced accountants, professional advisors and brokers to guide you on the value of the company. It is at this point a decision must be made on whether to use an intermediary to sell the company or to go it alone.

Methods of valuation
There are a number of methods of valuing a company. The following are most common:

1. Multiples of adjusted sustainable profit
This method uses the technique of applying an appropriate multiple to the sustainable (adjusted net profit) of a company, thereby arriving at a sale value. The multiple selected is applied to pre-tax or post tax.

Adjusted net profit
This is the company's reported historic or projected profits, adjusted for abnormal or non-recurring items, although expect any potential buyer to challenge the adjustments.

Non-recurring costs are those that would not be present when the owner or director has left the company, these are known as add backs.

Add backs can be:
# Directors' costs such as PAYE, salary, cars, pension and health cover (but not dividends).
# Fees paid to additional directors or individuals who will not be involved in the company in the future. Other non recurring costs can be added back, such as an exceptional bad debt or one-off costs that will not be repeated.
# If the removal of the owner would result in a replacement being required, the cost of the replacement needs to be re-introduced.

Calculating the multiple
Having established the adjusted net profit, it has to be decided what the appropriate multiple for the companies sector is.

The multiples for SME non-listed companies and businesses usually range from one to 10.

Owner run businesses are normally valued at between one and 2.5 times adjusted net profit.

Managed companies or businesses with profits up to £500,000 will attract a factor of between 2 to 7.

Companies with profits over £500,000 usually attract factors of three to 10.

There are a number of questions that will affect the chosen multiple

# Company Sector. Does the company operate in a sector that is in demand?
Are there many active buyers to push the multiple up?
Without demand in a sector it does not matter how profitable a company is, there will be a low factor applied.

# Niche sector. If the company operates in a niche sector it can add to the desirability, but if the sector itself is not in demand it is not relevant.

# Accounts.
The purchaser will want to see the last three years accounts. A high turnover, low profit company has little value compared to a medium turnover, high profit company. Most purchasers are looking for companies with increasing turnover and profit.

# Management Accounts.
After the historical accounts, good management accounts have a great impact on the valuation of a company. This includes not only the turnover and profit levels, but the quality of the actual information supplied, its consistency and the management systems that are in place to control the company.

# Turnover.
Although turnover does not determine the value, it does affect the type of purchaser. The larger the turnover, the more likely it is that the purchaser will be another company, rather than an individual. Corporate finance assisted purchasers generally look for companies with turnovers in excess of £10,000,000 and profits of plus £500,000.

# Profit.
Profit is the single most important factor in determining the value of a company, the greater the profit, the higher the base for the multiple. High profits allow for greater borrowing by the purchaser, thus a higher purchase price.

# Balance sheet/net asset value.
Does the balance sheet have items that are likely to confuse a purchaser?
Are the aged debtors within the industry norm?
Is the stock correctly valued?
Is there any dead stock?

# The owner's involvement.
Owner run companies where there is no middle or upper management attract a far smaller multiple than those that have a strong multi-layered management structure and are not owner dependent for their survival.

# Staff.
Is there one staff member that is key to the company's survival?
Are all the staff paid enough to keep them motivated?
When did they last receive a pay rise?
Are there any unusual bonus schemes?
Is there a key sales person?
Are all the key staff on contract?
Are there any pension schemes that are an issue?
Will the staff want to leave if the company is sold?

# Contracts
Is the company reliant on a key contract or contracts?
Are they transferable?
Are these all signed?
Are they long term?
Or are they in need of renewal?

# Suppliers
Is the companies supply chain secure?
Are there any supply contracts?
Are there any risks to the supply?

# Location
Location can affect the desirability for individual purchasers. If a company operates in an area that a company wishes to move into, this obviously increases the desirability.

# Property leases
Leases can cause far more aggravation and delay in a sale than any one single item.
Having all the property leases clearly detailed and secure will help the sale and assist a positive valuation.

Positive, clear answers on each of these questions could increase the multiple. However, each company requires individual analysis to determine the multiple and thus its market value.

2. Price/earnings (p/e) ratio
The P/E ratio is used in the valuation of larger listed companies. The P/E ratio is the ratio of the market value of the equity. This can be worked out pre or post tax. A high P/E indicates that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, it is necessary to compare the P/E ratios of one company to other companies in the same industry, or to the market in general, or against a company's own historical P/E to establish to true relevance of the companies' P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a software company (high P/E) to a manufacturing company (low P/E), as each industry sector has different growth prospects.

3. Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA)
EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is calculated by taking operating profit and adding back to it interest, depreciation and amortization expenses. EBITDA is used to analyze a company's operating profitability before these expenses are applied.

In conclusion
Whichever approach is used, determining an appropriate multiple for a private company is always going to involve a significant degree of opinion and subjectivity as only quoted companies have valuations which are readily accessible and which have been established by the market.

It is important if you decide to use an intermediary that they understand the SME sales market, as this helps give a more accurate valuation.