For those thinking of selling a business, the prospect of valuation may seem daunting. There are several different ways to approach valuing a business, all of which will depend on the unique circumstances and characteristics of each individual business.

Harry Barham, Supervisor, haysmacintyre explains what might be the best approach for you and your business, it can be helpful to start by understanding the three primary categories valuation methods fall into.

Comparable companies (comparable analysis)

This is a common method which uses a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), which is selected by evaluating a business’ characteristics within the industry in which they operate.

The comparable analysis includes, but is not limited to, forecasted growth, product or service mix and market positioning, and how these factors compare to others in the industry. The resulting multiple is then applied to the company’s EBITDA figure to arrive at the enterprise value. Different industries and market conditions yield varying multiples, and the quality of a business significantly influences these figures. Loss-making entities might be valued based on a multiple of revenue, a method particularly common in the growth phases of technology companies.

Intrinsic value (discounted cash flow analysis)

A more technical approach, this revolves around the ‘time value of money’ concept: cash now is worth more than cash later. This method involves building financial projections and estimating future cash flows. These cash flows, derived from operational activities and changes in working capital, capital expenditures and debt repayments, are discounted by a percentage reflecting risks, opportunity costs, and inflation. The sum of these present values forms the intrinsic value.

Asset-based valuation

This approach is less frequently used, except for industries where businesses have substantial assets, such as real estate. It focuses on assessing the assets held by a company rather than its trading value.

So why is EBITDA important?

Using EBITDA as a key metric in valuing a business allows us to assess companies on a like-for-like basis. It acts as a proxy for a business’ cash-generating ability, stripping away non-cash items from reported profits. However, EBITDA does not equate to cash flow, and there are other items to consider when valuing a business including capital expenditures, debt repayments, and working capital requirements.

To refine the EBITDA metric, adjustments may be made to exclude exceptional, non-recurring income or costs, such as owner remuneration or a discontinued division of the business. This process ensures a clearer understanding of the normalised EBITDA.

Other metrics for business valuation

While determining a company’s enterprise value is essential, the actual amount a vendor receives for their equity involves factoring in cash, debt, and working capital. In most M&A deals, transactions occur on a cash-free, debt-free basis, subject to a standard level of working capital.

In the context of a business acquisition, imagine having £100 in the company bank account with an enterprise value of £50. The preference, understandably, is for the full £150 rather than just £50. If the company has a £25 debt to the bank, the acquiring party inheriting this obligation is likely to seek a deduction, like the considerations in the sale of a house with a mortgage.

Beyond cash and debt considerations, the focus turns to working capital. The accounting definition of working capital is current assets less current liabilities, which includes cash. However, for mergers and acquisitions, cash is excluded to determine net working capital, a metric reflecting short-term operational liquidity. Net working capital considers the difference between current assets and liabilities expected to impact cash flow in the short term. This directly relates to the cash tied up in receivables and cash effectively advanced by suppliers depending on their standard payment terms.

Establishing a net working capital target (the peg) involves accounting for cyclical fluctuations. Typically, this is based on a 12-month average or occasionally in fast-growth scenarios, 6-months back and 6-months projected. The amount deducted or added to the enterprise value hinges on the difference between actual net working capital at completion and the agreed peg. A deficit prompts the buyer to seek a deduction, while a surplus obligates the buyer to pay for the excess. The intention is that the business leaves behind sufficient cash required for operations to continue as normal.

Enterprise value

In its simplest form, equity value can be established by subtracting debt from cash, and then either adding the surplus or subtracting the deficit in net working capital. This process, which in practice will require intricate calculations, involves negotiations and collaborative efforts from legal, accounting, and advisory teams to define what constitutes cash, debt and working capital – a process which isn’t always as straightforward as it might seem.

Appealing to acquirers

A business’ appeal to potential acquirers will centre on their strategic rationale for the purchase. Ambitions such as geographical expansion, product diversification or gaining a competitive edge can drive acquisition interest.

Beyond typical advice to optimise the business model, strengthen the market position and increase operational efficiency to appeal, it’s also recommended to enhance the ‘quality’ of earnings, focusing on consistency, growth, and diversification. Striving for strong and stable cash flow, while minimising debt, will only increase a business’ attractiveness to potential acquirers.

Read more:
Valuing your business for sale? The key methods to consider