Ultimately businesses will be valued through a process of negotiation between the buyer and the seller. There isn’t a single right answer, valuation isn’t an exact science.
The main reasons to value a business are:
- Incorporation of a Sole Trader or Partnership
- Internal reward systems
- Sale of the business or part sale
In order to value a business the valuer will need gather information such as
- Financial Accounts
- Management Accounts
- Details of liabilities
- Asset Valuations
- Market analysis
- Client Contracts
- Staff information and records
Not all this information will be available but essentially the more information that is available the more detailed and accurate the valuation will be.
The Valuer will also look at Strengths, Weaknesses, Opportunities, and Threats (SWOT).
The financials will need to be adjusted for exceptional and one off costs and any revaluation of assets and liabilities.
The Adjusted net assets then have a Goodwill or Bad Will adjustment applied to create the ‘Value of the Enterprise’
Lord MacNaghten in the case of Commissioners of Inland Revenue v Muller & Co Margarine (1901) AC215 defined goodwill as follows – he said:
“What is goodwill? It is a thing very easy to describe, very difficult to define. It is the benefit and advantage of the good name, reputation and connection of the business. It is the attractive force which brings in custom. It is the one thing which distinguishes an old established business from a new business at its first start. Goodwill is composed as a variety of elements. It differs in its composition in different trades and in different businesses in the same trade. One element pay preponderate here, and other there.”
The formula for Goodwill is
GW = Σ NCIt-rANAVt/(1+i)t
sometimes simplified to: GW = (NCI -rANAV)/i
GW = Goodwill
ANAV = operating adjusted net asset value
NCI = operating net current income
r = cost of equity
i = discount rate (weighted average cost of capital)
t = number of periods
In reality goodwill is much harder to establish in small businesses
Using Multiples is also a common approach to valuations, the multiple could be against
- Earnings per share (P/E ratio)
The multiple is assessed based on similar businesses which have been sold.
Another frequently used approach is Discounted Cash Flow (DCF)
The discount rate is usually the weighted average cost of capital (WACC)
WACC = ((ke x E)/E+D) + ((kd x D)/E+D)
WACC = weighted average cost of capital
ke = cost of equity capital
kd = cost of debt
E = Proportion of long-term funding from equity
D = Propertion of long-term funding from liablities
There are several ways in which DCF can be used to establish the business value.
Steve Bicknell holds the ACCA Certificate in Business Valuations and has carried small business valuations.