How much is your business worth?

How much is your business worth?

How much is your business worth?

The pithy answer to this question is: as much as someone is willing to pay for it. When Marks and Spencer announced in February that it will be paying Ocado £750 million for a 50% share of the new Ocado.com joint-venture, investors and analysts raised concerns that it had overpaid for access to Ocado’s technology and delivery network.

In fact, M&S shares fell by 12%, eroding over £550 million from the retailer’s market value – the biggest one-day fall since 2016. As Neil Wilson, the chief market analyst at Markets.com, said: “M&S’s purchase of Ocado’s retail business looks rather like one of its own ready meals – expensive, not very good for you, but easy, quick and ready to heat up.”

But how are trading companies typically valued? If you are contemplating exiting your business in the future, what is your “magic number”? And, once you know what that number is, what do you need to do to get there?

Historic profits as an indicator of future returns

Small and medium-sized businesses have traditionally been valued as a multiple of their historic post-tax profits. This makes perfect sense because, ultimately, an acquirer of a business is purchasing future profits, and often the most reliable (but clearly not fool-proof!) indicator of those returns is past performance.

In determining historic post-tax profits, however, it is necessary to consider a company’s average “maintainable earnings”. Maintainable earnings may be described as the level below which, in the absence of unforeseen and exceptional circumstances, the profit would not be likely to fall in an average year. After calculating maintainable earnings, a notional corporation tax deduction is made to arrive at the post-tax position.

For this reason, items such as exceptional bad debts, reorganisation costs or one-off legal fees are “added back” to reported profits to arrive at maintainable earnings. Equally, exceptional income (e.g. insurance pay-outs, rent from non-trading assets, etc.) will be deducted from actual profits in valuing a business, since, by definition, it is non-recurring or non-commercial.

For owners of small and medium-sized businesses, it is also important to be aware that, where dividends are the principal method of remuneration, deductions from reported profit will need to be made to arrive at the underlying commercial return of the company. For example, if a business-owner with the role of managing director takes £100,000 of dividends and a minimal £10,000 salary each year, then clearly the reported profits are going to be significantly higher than if a non-owner were in that position and being remunerated with a market-rate salary. For some businesses, that could deplete a significant portion of annual profits. However, like it or not, from a purchaser’s perspective, value is based on the return that can be achieved after factoring in market-rate adjustments such as these.

It is common to consider the last three or four years’ results in determining maintainable profits. Since the most recent performance is the best indicator of future returns, often these maintainable earnings are weighted in favour of the most recent years, but that is not a hard and fast rule. Of course, in a real transaction scenario, forecasts will also be reviewed by an acquirer to deduce maintainable profits.

What multiple?

So, you’ve worked out the company’s maintainable profit levels. Now an appropriate multiplier needs to be sought. There are various means to derive these, but unsurprisingly there is no publicly available record of transactions in shares of private, limited companies.

Here at Creaseys, we have access to several sources which allow us to estimate typical profit multiples, in addition to benefiting from the “real-world” knowledge which we gather from acting for clients who are buying or selling a business.

Are you contemplating making a new acquisition or selling your business? Let us help you with making that dream come true – call us on 01892 546 546.

One common source of reference for profit multiples is the price-earnings ratios (PER) of listed companies; by finding comparable public companies to your own business and halving their average PER, you can obtain a reasonably meaningful profit multiple (applying a 50% discount to the PER recognises the fact that private company shares are illiquid and less marketable).

Once you have your profit multiplier, you can apply this to your maintainable earnings number to produce a fair approximation of the value of your business.

It should be noted that EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) is increasingly being used to determine purchase prices in private-company transactions; indeed, for some sectors, this will be standard practice. Where this is the case, EBITDA multiples (not PER) need to be applied to adjusted EBITDA to arrive at what is often known as enterprise value.

Theory vs. practice

Going back to the often-used phrase that a business is worth as much as someone is willing to pay for it, the reality is that it is only when you market your company for sale that you will truly know its value. There may be purchasers in the marketplace who will pay a perceived premium for your business because it allows them entry to new customers (or indeed suppliers) or intellectual property, because they believe that they can substantially reduce overheads and other costs after the acquisition, or simply because of a defensive strategy to eliminate a rival. It is quite possible that, when it secured the deal with Ocado, Marks and Spencer knew something which the so-called analysts and experts did not.

That said, the theory behind business valuations gives you some steer to what your company might fetch in the open market, so that you are prepared for negotiations – or, arguably more importantly, so that you can think about what you can do right now to enhance the value of your business and get you to that “magic number”.

Talk to us

At Creaseys, helping clients to achieve their Big Picture vision – which may include the sale of your business – is what drives us, and that is underpinned by The Creaseys Way approach.

The content above is not by any means a complete summary of how to value a business, and should not be relied upon as such; there are many other matters to consider. If you would like to find out more, get in touch with Matt Neill, an Associate Director who heads up our Share and Business Valuations team, on 01892 546 546 or matthew.neill@creaseys.co.uk