This article ties in with the I'm Thinking Of Selling Up: How Do I Value My Business? article published on 16 October and Case study 2 - Cut and Run.
Methodologies
Valuers tend to choose earnings-based methods for valuing businesses where there is no great asset as they take more account of potential future profits, which is what most buyers are mainly interested in.
There are two common ways of doing this: using a price/earnings ratio (PER) and basing the valuation on Ebitda (earnings before interest, tax, depreciation and a mortisation). The first technique, with a different methodology, is also used by investors in listed companies as one of their tools in assessing companies. However, we are concerned in this article with the methodology applied to privately owned companies without publicly issued shares.
Here we look at one of two imaginary business owners, John. The other, Tiffany, is the subject of the second case study available here. John runs a small engineering business, Widgets R Us Ltd, is in his late 50s and has started to think about selling up with a view to retiring.
Widgets R Us
John’s company is fairly typical of one in its sector, with regular customers and turnover and profits that do not change much year to year. Both these things will help increase the multiplier used in the valuation.
Price/earnings ratio
Typically valuers will use the past three years’ figures,which in his case look like this.
table one
[Jamie, can you create a table similar to the one you used in the I'mThinking Of Selling Up: How Do I Value My Business? that shows three years’worth of figures.]
We can see from the table above that Widgets R Us makes an adjusted average profit of £xxx,xxx [please add].
The valuer takes this figure and applies the average of a number of price/earnings ratios to it with, in some cases, a discount applied to arrive at a valuation figure.
table two
[Jamie, can you create a table similar to the one you used in the I'mThinking Of Selling Up: How Do I Value My Business? that shows the P/E ratioaveraging and explain PCPI, Median P/E and Mean P/E]
The four ratios used are standard ones applied by valuers and the discount will reflect the company’s prospects, standing relative to its competitors and the expectation of consistent profits being generated in future. [Jamie, can youadd anything here?]
As can be seen in the table, the four P/E ratios are added together, three at the discounted rate, and divided by four to give a single figure of x.xx [please add]. The adjusted average profit is then multiplied by the average P/E ratio.
This figure will form the starting point for negotiations.
Ebitda ratio-based valuations
The valuer will take either the past year or the past three years of accounts as the starting point. The company’s Ebitda is used to create an agreed annual profits figure. Adjustments are made to the agreed profits figure to make it more representative of future years’ figures, and factors such as goodwill and other intangibles will be taken into account.
This figure is divided by the turnover, to generate the Ebitda ratio, which is expressed as a percentage. The higher the number, the more profitable the company is.
The Ebitda ratio is a measure of profit per pound of turnover. The Ebitda ratio will affect what multiplier is used. A company with a 45% Ebitda ratio will be able to demand a higher multiplier, eg, x4 rather than x3.5, than one with a 30% Ebitda ratio because it is more profitable. Generally, a smaller company will try to have the same Ebitda multiplier as a larger company.
The example here shows how using Ebitda to create a valuation works in practice.
[Ebitda valuation table similar to one in earnings-based valuation article to go here. Could you add turnover to it]
The Ebitda ratio equals earnings of £xxx,xxx divided by turnover of £xxx,xxx multiplied by 100.
[Text to come from me comparing the two results once the tables are in]
Get Professional Advice
Professional help is likely to be needed to value a business accurately. The friendly team at Finsbury Robinson will be able to deal with all your questions and give you a figure that you can take forward into negotiations. For advice on valuing or selling a business please call us on 020 8858 4303 or email us at info@finsburyrobinson.co.uk
