Pricing companies is a dark art. Your valuation and that of potential buyers are unlikely to tally, yet value it you must before you can begin any sort of sale negotiations.

Unfortunately, there are no hard and fast rules when it comes to determining the value of your enterprise, particularly a private business, but there are some guidelines suggested by those in the know.

As a crucial starting point, you need to be clear in your own mind about the amount you wish (or need) to realise and the best way to manage the sale ahead of exit negotiations.

But – and it’s a big, obvious but – your business is only worth the sum a buyer is prepared to pay, so you and your advisers should try to be objective. Aside from the financial calculations you can make, you will want to incorporate some estimate of inherent value, from goodwill or established systems. Here, it’s all too easy to be blinded by an emotional attachment into believing your business is worth far more than it really is when passed on.

Another consideration at the start is whether you and other key staff will be staying on as part of the sale or if you wish to exit the business entirely. This can be a major factor determining value.

Helpfully, there are a variety of valuation models used by different industries and sectors, which can give you an ‘objective’ measure of the worth of your business.

Valuing a company using Price-to-earnings

Various earnings multiples can be used as a business pricing guide. Price-to-earnings (p/e) ratios are the way the City, on the whole, compares differing companies in the same sector. As a widely used valuation measure of the relationship between a stock’s price and its earnings per share, it is also referred to as ‘multiple to earnings’ or simply, ‘the multiple’. It is calculated by taking the current stock price per share and dividing that by the most current earnings per share.

It’s an important tool for investors as it indicates how much they are paying for a company’s earning power. The p/e ratio may either use the reported earnings from the last year or employ a forecast of next year’s earnings (aka ‘the forward multiple’).

Assuming your business has a track record of profitability, a valuation can be worked out by multiplying profits by the average earnings multiple which companies in the same sector command. In the publicly-quoted sphere, profits are typically adjusted for exceptional items to arrive at an estimate of normalised earnings.

It’s worth noting that certain sectors are more highly rated than others. For instance, companies in the industrial transportation sector attract average p/e ratios of 34, those in leisure goods, 28 and those in media, 19. If you’re in industrial metals though, the average p/e is a lowly seven.

Moreover, if yours is a private business, you will almost certainly have to settle for a lower multiple than a quoted peer, since listed companies can be more easily bought and sold.

Other Valuation Methods

‘Selling a business is not like selling a house,’ says Howard Leigh, managing director of prolific and private business-focused Cavendish Corporate Finance. Leigh, a frequent lecturer on mergers and acquisitions, says there are countless ways of pricing a business, ‘based on profits, cash flows, assets, and sectors. Even with profits, the question arises, which profits?’

For more mature, cash generative businesses, a discounted cash flow analysis is recommended as the norm when trying to value a business at sale. In short, this is based on the future cash flows of your business. If you own a stable business with large tangible assets (such as plant and machinery used in heavy manufacturing businesses), then a valuation based on its assets could be used. Your net book value, refined to reflect recent asset value changes or bad debts, will be a good guide to the saleable price. Variations on book value are often used when an earnings multiple doesn’t apply, such as when your company is loss-making.

An ‘entry cost’ valuation, the cost for a rival to set up in your space in terms of buying equipment, employing staff or developing products, might also appeal. However, if entry costs in your industry are low, you are unlikely to successfully sell based on this. Ultimately, why would they buy your business when they could set up for themselves for the same cost?

Debt depresses value

A swathe of other factors will influence valuation, including your record of controlling costs and also the debt levels within the business. If the company owes a lot of money, this will often have to be subtracted from the amount that you finally receive from a trade buyer. Therefore, make sure you are realistic when calculating its negative effect on worth during the audit process.

David Whileman, an investment director at renowned private equity and venture capital giant 3i, says, ‘Valuing a company is as much an art as a science. Accountants are taught there are roughly six different ways of valuing a company, but in reality it all comes down to predicting the amount of cash the company will make over the years, valuing its assets, or using an earnings multiple.

‘It’s important to apply the valuation model suitable for the type of business as there are so many anomalies. Some businesses, such as recruitment firms, have hardly any assets, while others, like property companies, don’t generate much, if any, cash.

‘At 3i, we tend to look at profits and p/e ratios because these are the valuations the City uses. So, if an owner-manager comes to me and says, “My business makes £10 million,” I can open the Financial Times, see that the p/e ratio of that sector is eight, and estimate it’s worth around £80 million.’

Referring to lessons learned from the dotcom boom, when pre-revenue, pre-profitable companies traded on overly optimistic ‘blue-sky’ multiples, Whileman says, ‘The one thing that’s always a rock solid guide is profit. We’ll look at profits growth, and ask ourselves whether we can get a better p/e for the business in two or three years’ time.’

Smell the air

‘Be shrewd and smell the air,’ adds Cavendish’s Leigh. ‘The value you achieve depends on selling at the right time. In the past, businesses were handed down through families, whereas today, people tend to be serial entrepreneurs looking to sell at the best time as dictated by market conditions.’

Macro factors, such as the state of the economy and conditions in your sector at the point of sale, will come into play, not to mention the question of supply and demand. How many potential buyers and offers are on the table? If there are a few, you might be able to play them against each other and raise the price, though it’s a risky game that can easily backfire and scare buyers off or engender bad feeling.

It’s also worth bearing in mind that strategic buyers, desperate to assume geographic advantage or access to your prized customer base, are likely to pay more for your company than financial opportunists.

Whileman also advises that the whole pricing process should be conducted early, since trade buyers usually prefer a handover period rather than buying an owner-manager out in one fell swoop. ‘Trade buyers tend to use deferred consideration more than private equity houses because they are more interested in securing the long-term success of the business. You should factor in a handover period of at least six months, maybe even longer. So if you plan to be sitting on beach at the age of 65, you’ll need to start the sale process at 63.’

Don’t under-sell intangibles

Hard numbers – profits, cash and hard assets – are fairly black and white guides to use when pricing. Intangible assets, however, are murkier entities that you’ll need to try and quantify because they can radically alter the pricing of your enterprise. Make sure your valuable people, brands, patents, copyrights and licences are understood by potential buyers and fully recognised in the price. Creating and then managing intangible assets can be crucial to realising the long-term value of your business.

Trademarks and patents are legally enforceable intangible assets that should underpin pricing, but make sure you don’t forget about the goodwill within your business.

Relationships built up with customers, internal corporate culture and staff relationships – these are all important assets. When taken into account, they can help you leverage a better price, so make sure your business advisers understand and convey their value to potential purchasers of your enterprise.

Your brand has value

Brand value is often a company’s most valuable asset and a thorough brand valuation will help negotiate a better sale price. The new International Financial Reporting Standards code has put a spotlight on the issue, with brand valuations now mandatory for acquired brands of European companies.

‘Intangible assets are much neglected by owner-managers and investment bankers when readying a company for trade sale or flotation,’ argues intangible asset valuation sage Thayne Forbes. Joint managing director of Intangible Business, the brand valuation consultants, he recalls a recent case in point. ‘A well-known directories business issued a prospectus during its initial public offering (IPO) that contained hardly anything about brand, the key driver of that business. Many companies are paying only lip service to their brands in communications with the City and with potential trade buyers.’

Intangible Business advises clients ranging from small owner-managed concerns to Fortune 500 behemoths. Forbes says, ‘We help them put the spotlight on why the business is attractive from an intangible asset/ brand point of view.’ He advises that firms run the rule over intangibles with accountants and lawyers when valuing these aspects. ‘Before even considering putting your business up for sale, it’s worth doing a legal audit to see what the legal basis is for intangibles. Have a check to see what rights you have.’

There are plausible ways of measuring intangible assets, from calculating what it would cost a rival to duplicate your brand, researching past brand sales in the sector, and also forecasting the future sales and profits benefits your brand (and other intangibles like patents) will bring to your business and the acquirer. But rather than do this alone, the general consensus seems to be that advice from the experts will be money well spent if it helps you realise the full value of the business you’ve built.