How to Value a Business

Learn all about the different valuation methods here

How to Value a Business

Discounted cashflow

This is the best method of valuing a business which is generating steady income and reliably expects to do so in the future. It is not a suitable way of valuing a start-up or a business in a sector which is rapidly changing, as it works by assuming that long-term business prospects will remain relatively steady. It works by “discounting” the value of future cashflow, on the principle that cash expected to come in in the future is worth less than cash today.

To calculate the value of a business using this method, use the following general formula:

  • Add up the sum of your company’s forecasted dividends over a 15-year period
  • Apply a ‘discount rate’ reflecting the principle of ‘time value of money’
  • Arrive at a valuation

This is a highly technical formula, and it is too complex to cover the whole method in this article – click here for a step-by-step guide.

Industry rules of thumb

In some sectors where exits are particularly common, businesses are not valued using the standard formulas we explored here but using some standard rules of thumb used by buyers in the particular sector.

Rules of thumb will differ according to which sector the business is in: for example, dry cleaning businesses are valued at between 75 to 90% of gross revenues, whilst optometrist practices sell for the value of their net fixed assets added to the most recent year’s net income. You should do a web search to see if rules of thumb apply to your particular sector, and what the formula is.

‘Entry cost’ valuations

Before you buy a business, it is generally a good idea to conduct an entry cost valuation; essentially, this works out how much it would cost you to set up a new business in a particular market, rather than buying an existing one.

To calculate an entry cost valuation, you simply work out how much it would cost your business to set up in a particular market from scratch. This should take into account costs including:

  • The cost of finance
  • Product development
  • Capital expenditure on assets
  • Fixed costs of utilities, premises and so on
  • Staff hires, training and wages
  • Sales and marketing

When you have arrived at your entry cost valuation, you can compare it with the valuation of a business you are proposing to buy to work out which is the most cost-effective option. Remember that you introduce a large amount of risk to the equation whenever you start from scratch and there is always the chance your new venture will fail to take off, even if all the ingredients are in place. So even if a business you are looking to buy will be much more expensive than starting from scratch, see if you can work out whether the difference is accounted for by the fact it may be an established business with a good track record.

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