It is important to note that there is no definitive valuation methodology for a business, since most models rely upon various subjective assumptions. Whichever business valuation model you use or assumptions you make, ultimately the value of the business comes down to what both parties agree it is worth.
Start-up businesses (especially pre-revenue ones) can get very carried away with high business valuations. Think: would someone buy what you have created so far at this valuation? Probably not.
Usually, you will show the valuation of the business as a range, by changing the key assumptions in the model.
There are various models that can be used to value a business. Some of the more popular ones are outlined briefly below.
- Net asset valuation model
This is the most basic form of valuing an existing business. It looks at the net asset value as shown on the balance sheet, i.e. all assets of the business, less liabilities.
- Comment: The most basic model, but it does not take account of the future earnings capability of the business and its assets.
- "Sweat equity" model
The value of the business corresponds to the total equity injected, plus an amount for the entrepreneur's time taken to develop the idea.
- Comment: A fairly basic valuation model with relatively few assumptions and variables.
- Price/earnings model
This model is useful for calculating a valuation at the exit point, e.g. after three to five years, to provide an estimate of the investor's return on investment.
For a quoted company, the price/earnings ratio is the quoted share price of the company divided by the (usually one year forecast) earnings per share. Find an appropriate P/E ratio by (1) comparing your business with similar quoted businesses and (2) discounting the ratio (sometimes significantly) to reflect the reality that your business is worth less than a quoted counterpart.
Once you have established a P/E ratio, multiply the business's projected annual net profit after tax (earnings) by this figure, in order to assess the value of the business (price).
For example, if the P/E ratio is 6 and your projected earnings are £100,000, your P/E valuation for the business is £600,000. This assumes that the future earnings of the business are £100,000 per annum.
- Comment: Determining a P/E ratio for your business can be a very subjective exercise.
- Discounted cash flow (DCF) model
An investor purchasing shares in a business is, in effect, purchasing a share of the business's future cash flow (in the long run broadly represented by profits after tax). The DCF model discounts this cash flow back to a single figure, to derive a value for the business, using an assumed discount rate.
The discount rate should reflect an investor's desired investment return over the life of the investment.
- Comment: Again, the choice of discount rate is crucial and highly subjective.
- Sales and profit multiples
This is a simple method that multiplies the sales or profits at exit by a multiplier. The multipliers are based on industry standards or sales of comparable businesses.
- Comment: A good way of testing the reasonableness of other valuation methods, although again the multipliers are subjective.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
