How to value your small business: a guide

The discounted cash flow method is one of the trickiest ways of valuing a business.

This is an income-based approach to business valuation that’s focused on working out what a future stream of cash flow is worth today. It tends to be used by established businesses who project stable, predictable cash flows for the years ahead.

To work out the present value of future cash flow, you apply a discount interest rate to cover any risk (such as unexpected costs or bills) and the time value of money. The time value of money is the idea that £1 earned today will be worth more than £1 gained tomorrow due to its earning potential.

This method of valuation is most often used when seeking investment and allows potential investors to forecast whether or not a business could pay them back within the desired timeframe. To get this estimation, you look at the projected forecast over the repayment period and take off the discount rate.

In the end, if the calculated amount is higher than the initial investment, then it’s likely an investment worth keeping in your sights. There’s a full example of how this works in a later section, just in case that was a little bit hard to follow.

An easy but popular approach to valuing your business, the comparable analysis method involves assessing the value of businesses similar to yours. Comparable analysis gives an observable value for your own business, based on what rival or similar companies are worth at present.

In order to do this, you’ll use some of the valuation methods discussed later in this article such as the price/earnings ratio, or other methods such as enterprise value/EBITDA. You’ll use these to value a similar company and take that to be a relative valuation of your company.

However, a publicly traded company is usually worth more than a private company due to its marketability and liquidity, so if you’ve used data from a publicly traded company, you may need to apply a discount to your valuation if your business is private. Often this discount can range between 30% to 50%, but it is worth consulting a financial analyst to find out the correct rate for your industry and business.

Similar to comparable analysis, this method uses evaluation of other similar businesses to gauge what yours might be. In this case, you’ll look at businesses which were recently sold or acquired in the same industry. As these would likely include some takeover premium which accounts for the future value of the business, it’ll be particularly useful if you’re valuing in order to sell your business.

The caveat to this method is that the data goes out of date quite quickly, so you’ll have to do this regularly if you want an accurate reflection of current market conditions. Just like comparable analysis, you may also have to apply a discount to your valuation if you’re using a publicly traded company as a point of comparison for a private company.

The caveat to this method is that the data goes out of date quite quickly, so you’ll have to do this regularly if you want an accurate reflection of current market conditions. Just like comparable analysis, you may also have to apply a discount to your valuation if you’re using a publicly traded company as a point of comparison for a private company.

The industries where the selling of businesses take place frequently – such as retail, where business turnover, customer volume and outlets are key indicators of value – might have specific rules of thumb that you can use as a guide to lead you through your business valuation process.

An entry valuation framework model values a business by working out how much it would cost to establish a similar business. Essentially it’s asking ‘if my business didn’t exist, how much money would it cost to start it from scratch, right now?’

A good way to get an accurate estimate is to create a list detailing start-up costs, the price of acquiring tangible assets, employing and training staff, establishing a customer base, and developing products and services.

Once you have this costs list in place, consider how you could be as thrifty as possible when setting up. For example, you might be able to save some of your hard-earned cash if you set up your business in a cheaper location or opt for more cost-effective equipment.

After working out these savings, subtract them from your projected start-up costs. Ta-da, you’ve worked out the value of your business based on your entry valuation cost!

This would only give you the value of a business at a specific point in time and wouldn’t help with predicting the future value of a business. It may be helpful for extremely new or niche startups to use, but once you have a bit more financial history or competitors, there are more widely accepted methods to use.

Entry Valuation Cost = Projected Start-up Cost - Potential Savings

If your business has sizable assets, then an asset valuation could be an ideal way to get to grips with the overall value of your business.

There are two types of asset: tangible and intangible. Tangible assets are the physical things belonging to your business, such as your business premises, stock, land and equipment. Intangible assets are any non-physical assets, such as your business’ brand, reputation and intellectual property including copyrights and patents.

To get the Net Book Value (NBV) of your business, you subtract the costs of your business liabilities (such as debt and outstanding credit) from the total value of your tangible and intangible assets.

It’s a good idea to regularly update records of your assets so that their value takes inflation, depreciation and appreciation into consideration, to help keep your asset valuations accurate.

Often, this asset valuation method yields the lowest value for a business because it doesn’t take into account any ‘goodwill’ towards the business – a technical accountancy term that covers the difference between a company’s market value (what people are willing to pay for it) and the value of its net assets (assets minus liabilities).

The times revenue method is often used for young companies that don’t have enough earnings history to use other models. This model takes the revenue for a business, usually over the course of a year, and multiplies it by a number unique to their industry. Often this will be between 0.5 and 2 with the low numbers being used for industries that are slow growing and higher numbers for industries that are expected to expand. Consult a financial advisor to find out what the right multiplier is for your industry.

This is not the most reliable form of valuation because revenue does not always equate to profit and this method doesn’t consider the expenses of a company and its’ ability to produce a positive net income.

Relevant equations:

Times revenue valuation = revenue x industry multiplier

This valuation method compares the price of company stock to the profit a buyer can expect to make from it. Often the share prices and the earnings amounts will be an average from these numbers over the past twelve months. Your price/earning ratio may be compared with other businesses in your industry to decide if it is subpar, average, or above average.

A high P/E might indicate that a business’ stock price is high in relation to their earnings and that the business might be overvalued. In contrast, a low P/E means that the stock price is low compared to earnings and the business may be undervalued.

For larger SMEs that have gone public, this is the most widely used valuation method, however it is not possible to use for smaller businesses that are still privately owned as there won’t be stock prices available to use.

If you’re a private company, you might want to look into other ratios that could be relevant to your industry such as revenue/cost.

Relevant equations:

Price/earning ratio = share price/earnings per share

Going beyond financial formulas: Not all assets and value can be measured therefore looking at intangible assets such as logo, reputation, geographical location etc. alone is still just as important as looking at formulas alone.