How to value a business

Revolut Contributor

 · 06/10/2020  · 06/10/2020

Businesses are the backbone of the economy. From bootstrapped start-ups, to fast-growing scale-ups to established corporations, businesses ensure the circular flow of income. Business success can be measured on several different metrics, but perhaps the most popular is valuation. But how to value a business?

Publicly-traded companies are able to refer to their share price and associated market capitalisation to show their valuation, but how can you value a business, public or private?

Valuations are crucial in any merger and acquisition (M&A) activity, fundraising process or initial public offering (IPO). But beyond that they’re also a sign of genuine growth prospects for the business.

So, how can you value a small business?

Principles of Business Valuation

Valuation is both an art and a science, and involves analysis of several factors and data points to arrive at a company valuation.

Financial metrics, such as revenue, gross profit, and EBITDA will most likely feature in your valuation analysis. But other factors will also feature, such as likely growth in the consumer base for the market in question, as well as the barriers to entry for the industry, and whether there is any threat of regulation impacting  growth.

There are also intangible assets that need to be considered. Is there any Intellectual Property for instance? If so, this needs to be factored into the value of the business. Similarly, are there key relationships, or a particularly strong brand? If so, these will add to the Goodwill of the business, and should also be considered.

As you can see, valuation is no easy task, and that is why investment banking analysts and venture capitalists spend entire careers researching and deciding on company valuations.

Here are three ways to value a business:

1. P/E Ratio method

The price to earning (P/E) ratio is commonly used for publicly traded companies. This ratio takes the price of the shares in question, and expresses it as a ratio of earnings per share. If a business is said to be trading on a P/E ratio multiple of 10, that means that the investor is paying £10 in equity for every £1 of company profit. As a result, a higher P/E ratio means the investor is willing to spend more for the asset, with the expectation of higher earnings growth in the future.

Different industries have different typical P/E ratios. The S&P 500 has traditionally fluctuated between 13-15 as a P/E ratio average. Software companies are infamous for having large P/E ratios, Amazon’s is currently at 114, for example. This is due to the high growth expectations of the company and/or industry in question. Meanwhile a sector such as homebuilding has a forward P/E ratio of 12.5.

This variance is due to a few different factors, including long-term prospects for the industry and current profitability status. Amazon was famously loss-making for several years but still maintained a high P/E ratio and increasing share price due to the strength of future prospects.

2. EBITDA Multiple method

The EBITDA multiple method of valuation is fairly popular. This is a fundamental approach to business valuation, as it takes EBITDA from your profit & loss statement and applies an industry multiple to arrive at your valuation. An industry multiple takes the industry standard between valuation as a multiple of EBITDA. Therefore, you can use the same multiple, apply it to your EBITDA, and get a reasonable valuation as compared to your peers.

The advantage of this method of company valuation is that it is based on actual results for the company, and you can apply an industry standard multiple to have a realistic valuation.

The primary drawback of this approach to company valuation is that it does not work for pre-profitable companies, such as technology start-ups. These companies will not have positive EBITDA due to the significant amount of capital they are investing into product development as well as acquiring customers faster than their competitors.

An additional disadvantage to this approach to valuation is that you may not have insights into comparative company multiples. This makes it difficult for analysts to arrive at a realistic multiple to apply.

Learn more about EBITDA here.

3. DCF method

Perhaps the most common method for valuing an early-stage business, is the Discounted Cash Flow method. This approach works back from expected future cash flows, applying a discount rate to arrive at the present value of expected future cash flows, and therefore the company valuation.

As a result, this approach gives a bit of science to valuing a loss-making or pre-revenue company, as analysts can model predicted future cash flows and then work back from there in order to arrive at a present-day valuation.

Detractors from this method highlight the lack of certainty over future cash flows as a weakness in the methodology. Like any forecast, the further out you project, the more likely that the forecast will not be accurate. Several microeconomic and macroeconomic factors can impact such projections. Covid-19 is one recent example which was almost certainly not part of any business’s forecast model at the start of the year.

Despite this critique, the DCF method of company valuation remains popular, particularly for high-growth technology companies, that are loss making for several years to pursue aggressive growth strategies.

M&A considerations when valuing a business

When deciding on a valuation for buying or selling a business (M&A activity), there are a few other factors that you should consider, and which can, at times, lead both buyer and seller to believe they have a good deal. These are often referred to as synergies.

If you are buying a business in a similar vertical to your current business, you may be able to rationalise costs across the two businesses, by having 1 office rather than 2, for instance. This will then reduce your expenses, improve your profitability and lead to you ascribing a higher valuation to the business.

The seller, on the other hand, will not be able to model these cost savings out and therefore may be willing to sell to you based on the result of their valuation model, that comes to a discount of the value you ascribe to the business.

Another possible synergy would be for an acquisition to increase your market share, and therefore reduce your variable cost as you will be able to benefit from a volume discount for components, due to economies of scale. This then makes the breakeven point lower and therefore there is greater chance of surplus profits following the acquisition or merger.

So as you can see, valuation depends on your perspective and sector. There are popular models of quantitative analysis for valuing a business, such as DCF and EBITDA multiple, although these also have qualitative assumptions driving them, such as expected growth in total addressable market and socio-economic factors.

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About the author

Matt is the Head of Operations (EMEA) for Fathom, looking after sales, support, account management and partnerships. Prior to becoming Fathom’s second EMEA employee, Matt was Head of Customer Experience at a scaling SaaS Plc, and he has consulted to clients ranging from sole traders to FTSE100 constituents. Matt is originally from a legal background and has experience in litigation, M&A deals and negotiating international commercial contracts.