Andrew Markou is the CEO and Co-Founder of BusinessesForSale.com. He has extensive experience in the business for sale market and the factors that influence valuation. He is also the author of A Pocket Guide to Buying a Business, which explains the acquisition process and explores how buyers can assess what a business is worth.
What is a business worth?
It sounds like a simple question. Unfortunately, there is rarely a simple answer. A seller might have one figure in mind based on the time, money and energy they have invested in their business. A buyer may arrive at a very different number after examining its profits, assets and risks. Neither figure necessarily represents what the business will eventually sell for.
After more than 30 years of helping owners bring businesses to market in the UK and worldwide, we know that valuation is part calculation and part judgement. The numbers provide a starting point, but the value of any business is ultimately what a buyer is willing to pay for it – and that means negotiation, as well as a lot of accounting.
In this guide, we will explain how to value a business using the most common valuation methods and formulas. We will also look at how buyers and sellers approach valuation differently, what can make a business more or less valuable and when it is sensible to seek professional help.
Tip: If you want to know how to value a business quickly, our free ValueRight business valuation calculator can provide an initial valuation before you explore these methods.
How Do You Value a Business?
A business can be valued according to its earnings, assets, revenue, future cash flow or the prices paid for comparable companies. For many profitable small businesses, a common starting point is:
Indicative business value = Maintainable earnings × Appropriate valuation multiple
Maintainable earnings are the profits a buyer could reasonably expect the business to continue generating. Multiples are subjective benchmarks determined by a few factors: the performance/risk of the business itself, financial information from public companies in the same sector, and sales of comparative businesses. These can get a bit slippery, but we break down all the essential info in the below section What is a Valuation Multiple – and How is it Chosen?
It’s also worth noting that the formula above will not suit every company. An asset-heavy manufacturer, a small owner-operated shop and a fast-growing technology business may each require a different approach. Read on to understand the different valuation methods in detail, including which ones suit which kind of business.
Why is Business Valuation Important?
You’ll need an accurate valuation of any business before you buy or sell it. For sellers, it’s about ensuring that your asking price can be backed up by cold, hard numbers – not just your subjective idea of how fantastic your business is. For buyers, it’s about ensuring that you get exactly what you’re paying for. You may also need a valuation when:
- Applying for finance
- Bringing a new investor or shareholder into the business
- Planning your retirement or succession
- Transferring shares between owners
Even if you have no immediate intention of selling, understanding how buyers would value your business can reveal weaknesses and opportunities. It can help you build a more resilient company now and secure a better result if you eventually decide to sell.
What Information Do You Need to Value a Business?
The quality of a valuation depends on the quality of the information behind it. Before you begin, try to gather the following:
|
Information |
Why it matters |
|
Profit and loss accounts for at least three years |
Shows revenue, costs, profitability and performance trends |
|
Recent management accounts |
Provides a more current picture than the latest annual accounts |
|
Companies House filings |
Provide a useful public record, although not always up to date |
|
Balance sheets |
Records assets, liabilities, cash and debt |
|
Cash-flow statements |
Shows how effectively reported profits translate into cash |
|
Owner salaries and benefits |
Helps calculate the true financial benefit received by an owner |
|
Discretionary and non-recurring expenses |
Identifies legitimate adjustments to reported profit |
|
Asset register |
Lists equipment, property, vehicles and other business assets |
|
Outstanding debts and liabilities |
Helps distinguish the value of the operations from the value attributable to shareholders |
|
Revenue by customer |
Reveals whether the business relies too heavily on a small number of customers |
|
Contracts and recurring revenue |
Helps assess the predictability and transferability of future income |
|
Forecasts and sales pipeline |
Provides evidence of future opportunities, although projections should be treated cautiously |
|
Details of leases, licences and intellectual property |
Identifies important rights, commitments and intangible assets |
Buyers are likely to test the information presented to them during due diligence. Incomplete accounts, unexplained costs or overly optimistic forecasts can reduce their confidence - and the amount they are willing to pay.
What are the Different Methods for Valuing a Business?
Most traditional business valuation methods fall into three broad categories:
- Earnings-based methods , which focus on the profit or financial benefit generated by the business
- Asset-based methods , which assess what the business owns and owes
- Market- and future-based methods , which consider comparable transactions, revenue or expected future cash flow
The right method will depend on the type of business and the purpose of the valuation. There is no single correct answer to how to value a company, so it is important to understand how each approach works.
1. Seller’s Discretionary Earnings
Seller’s Discretionary Earnings, or SDE, is commonly used to value small and medium-sized owner-operated businesses.
It starts with the company’s reported profit and adds back certain costs or benefits associated with the current owner. These may include the owner’s salary, personal benefits, interest, depreciation, amortisation and genuine one-off expenses. The aim is to estimate the total annual financial benefit available to one full-time owner-operator.
What Businesses are Best Suited to SDE Valuation?
SDE is generally best suited to smaller businesses where the owner works in the company and takes a salary or other benefits from it. Examples could include independent shops, cafés, trades, agencies and local service businesses. It is particularly relevant when the buyer intends to replace the existing owner and perform a similar role.
What is the Formula for SDE?
SDE = Pre-tax profit + owner’s salary and benefits + interest + depreciation and amortisation + eligible discretionary expenses + non-recurring expenses
Once SDE has been calculated, a suitable market multiple is applied:
Indicative business value = Maintainable SDE × SDE multiple
A Simple SDE Valuation Example
Imagine a small marketing agency reports annual pre-tax profit of £100,000. Its working owner receives a salary of £50,000. The accounts also contain £10,000 of legitimate personal or one-off expenses that a new owner would not inherit. Its SDE would therefore be:
£100,000 + £50,000 + £10,000 = £160,000
If evidence from comparable businesses supports an SDE multiple of three, its indicative value would be:
£160,000 × 3 = £480,000
This does not guarantee that the business will sell for £480,000. The multiple still needs to reflect its growth, customer base, owner dependence, sector and other risks.
2. EBITDA Multiple
EBITDA stands for earnings before interest, tax, depreciation and amortisation. It is used to assess the underlying operating profitability of a business before financing decisions, tax and certain non-cash accounting expenses are considered.
What Businesses are Best Suited to EBITDA Valuation?
EBITDA multiples are more commonly used for larger, established businesses that have a management structure and are not entirely dependent on the working owner. Unlike SDE, EBITDA does not assume that one owner’s entire salary can be added back.
What is the Formula for EBITDA?
EBITDA = Net profit + interest + tax + depreciation + amortisation
The valuation formula is:
Enterprise value = Maintainable EBITDA × Appropriate EBITDA multiple
EBITDA can make it easier to compare companies with different financing and accounting structures. However, it should not be mistaken for cash flow. It excludes capital expenditure and changes in working capital, both of which can have a substantial effect on the money a business actually generates.
I discuss some of these considerations in our video on business valuation and the M&A process .
3. Asset-Based Valuation
An asset-based valuation considers the value of everything the business owns and subtracts everything it owes. The simplest version uses the company’s balance sheet:
Net asset value = Total assets − total liabilities
Assets could include property, equipment, vehicles, stock, cash and money owed by customers. Liabilities could include loans, unpaid bills, tax obligations and other debts.
What Businesses Are Best Suited to Asset-Based Valuation?
Asset-based methods are most useful for businesses whose value is closely connected to tangible assets. These may include property companies, manufacturers, agricultural businesses and companies with valuable equipment or stock. They are generally less useful when most of the company’s value lies in its people, brand, customer relationships or ability to generate future profits.
Book Value vs Fair Market Value
The value shown for an asset on a balance sheet may not reflect what it is currently worth. Equipment may be worth substantially less than its original purchase price, while property acquired many years ago may be worth more. Some stock may be difficult to sell, and not every customer debt will necessarily be collected in full. It’s important you factor in fair market value – not just book value – depending on the asset you’re valuing.
Liquidation Value
Liquidation value estimates how much the company’s assets would realise if they had to be sold and its liabilities settled. A forced or time-limited sale will often produce less than an orderly sale on the open market. For that reason, liquidation value may be used to establish a floor valuation for a distressed or underperforming company rather than the expected value of a healthy trading business.
4. Discounted Cash Flow Valuation
Discounted cash flow, or DCF, is one of the more mathematically complex valuation methods. It values a business according to the cash it is expected to generate in the future, and reflects the time value of money: £10 received today is worth more than £10 received several years from now because today’s money can be invested. The business’ forecasted cash flow is therefore reduced using a discount rate that reflects time and risk.
DCF value = [CF₁ ÷ (1 + r)¹] + [CF₂ ÷ (1 + r)²] + … + [CFₙ ÷ (1 + r)ⁿ] + discounted terminal value
- CF is the forecast cash flow for each period
- r is the discount rate
- n is the period number
- Terminal value represents the estimated value of cash flows beyond the explicit forecast period
What Businesses are Best Suited to DCF Valuation?
DCF is most useful for businesses with sufficiently predictable cash flows and credible long-term forecasts. It is often used for larger companies and investments where future performance is more informative than one year’s historic profit.
Its principal weakness is its sensitivity to assumptions. Small changes to forecast growth, future margins or the discount rate can produce a significantly different valuation. It should therefore be used with caution when earnings are volatile or reliable forecasts are unavailable. In the UK, DCF is an established professional method, but it is often less practical for smaller private companies because dependable long-term cash-flow forecasts may not be available.
Which Business Valuation Method Should You Use?
No valuation method is best in every situation, but the following table provides a starting point:
|
Type of business |
Potential starting method |
|
Small owner-operated business |
SDE multiple |
|
Established company with independent management |
EBITDA multiple |
|
Asset-heavy company |
Adjusted net asset valuation |
|
Distressed or loss-making business |
Asset-based or liquidation valuation |
|
Stable company with predictable future cash flows |
Discounted cash-flow valuation |
In practice, using more than one method can produce a more reliable range, and many brokers or accountants will do just that. Comparable transactions can then test whether the result is consistent with the market.
What is a Valuation Multiple – and How is it Chosen?
Valuation multiples are benchmarks which are affected by the risk/performance of your business, other businesses within the same sector and sales of comparable businesses. They are not set in stone, but are subjective figures determined by how the market changes and by negotiation between buyers and sellers. Keep in mind that multiples are an art, not a science, and should be treated as such throughout the process.
If several similar companies have recently sold for between 2.5 and 3.5 times their SDE, that provides a potential range against which another business can be assessed. However, finding genuinely comparable transactions is not always easy. Private sale prices are frequently confidential, and two businesses operating in the same sector can still differ significantly in size, location, margins, growth and customer base.
Brokers, accountants and professional valuers may also use specialist transaction databases, published sector research and their own experience of completed deals. The more relevant and recent the evidence, the more defensible the multiple should be. Across the UK, location can also influence property and labour costs, access to customers and the depth of the local buyer market – all of which may affect the multiple a buyer is prepared to pay.
For buyers and sellers, you should never take a multiple as gospel but always question it, and investigate whether it holds up to scrutiny. Remember that if you buy a business valued with an overly optimistic multiple, the only person accountable at the end of the day is yourself. That’s why you conduct thorough due diligence – to avoid nasty surprises.
Five Common Business Valuation Mistakes
Valuing a business isn’t easy, and there are plenty of common mistakes people make during the process. Here at BusinessesForSale.com, we’ve seen a lot of them first hand across 30 years of transactions supporting buyers and sellers. Here’s five of them you should avoid:
Applying a Multiple to the Wrong Figure
SDE, EBITDA, net profit, revenue and cash flow are not interchangeable. A multiple derived from SDE-based transactions should be applied to SDE, while an EBITDA multiple should be applied to appropriately adjusted EBITDA. Mixing the two can significantly distort the valuation.
Making Unrealistic Adjustments to Profit
Sellers naturally want to demonstrate the highest possible level of maintainable earnings. This can lead to too many expenses being added back. Personal costs and genuine one-off expenses may be legitimate adjustments. However, a cost cannot be removed simply because the seller would prefer the buyer not to count it.
Relying Too Heavily on One Year
One exceptional year does not necessarily represent what the company can continue earning. A valuation should examine performance over several years, recent management accounts and the reasons behind any upward or downward trend.
Double-Counting Assets
When a business is valued according to its earnings, the assets required to generate those earnings may already be reflected in the result. Adding the full value of its ordinary equipment, stock or premises afterwards could count the same economic value twice. The transaction should clearly state which assets are included and whether any surplus or non-operating assets are being valued separately.
Treating the Valuation as a Guaranteed Sale Price
A valuation is an informed estimate, not a promise. The final price will depend on buyer demand, due diligence, finance, negotiation and the structure of the deal. New information uncovered during due diligence may change the buyer’s view, while competition between several credible buyers may push the eventual price upwards.
Can You Value a Business Yourself?
If you want to understand how to value a business yourself, the formulas in this guide can help you produce an indicative valuation range – provided you have accurate financial information. For a more detailed analysis, BusinessesForSale.com’s ValueRight business valuation tool examines the financial information behind the business in greater depth.
For a formal valuation – particularly one required for tax, legal or shareholder purposes – consider seeking professional business valuation services from a UK chartered accountant, business broker or qualified valuation specialist.
Finding the Right Value
No single formula can capture everything that makes a business valuable.
Its accounts matter, but so do the reliability of its earnings, the strength of its customer relationships, its dependence on the owner and the risks a buyer will inherit. The most credible valuations combine sound financial analysis with a realistic understanding of the company and its market.