Demystifying the process of valuing a business for sale

It can be hard to know how to begin going about valuing your business for sale. The number of different approaches can seem endless.

Harry Barham, Supervisor at haysmactinyre, offers advice for London business owners on how to navigate this problem and work out which of the three main categories of valuation is best for their business.

1. Intrinsic value (discounted cash flow analysis)

This approach centres on the idea that cash now is more valuable than cash later, known as the ‘time value of money’ concept. It is a technical-heavy approach and requires the development of financial predictions and an approximation of future cash flows.

These cash flows can derive from sources including: capital expenditures, debt repayments, and operational activities and changes in working capital. The cash flows are then reduced by a discount factor calculated based on risks, inflation, and opportunity costs. They are then added together, along with a terminal value, to arrive at the intrinsic value.

2. Asset-based valuation

This approach is primarily used by industries such as real estate – where businesses have substantial assets. When carrying out an asset-based valuation, the trading value of a company is not assessed – but rather the assets it holds.

3. Comparable companies (comparable analysis)

Lastly, we come to the most common method. This approach utilises a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation), which is arrived at by analysing a business’s position in the context of its wider industry.

This industry comparison could look at, for instance, product or service mix, market positioning, and forecast growth. The resulting multiple is then applied to the company’s EBITDA figure to generate the enterprise value. The wide range of different industries and market metrics for comparison means multiples can vary greatly – whilst the quality of the business in question of course also impacts the final figure.

To illustrate one of the many combinations available – when valuing a technology company in its initial growth phases and while it is still loss-making, it is often most effective to base the valuation on a multiple of revenue.

Despite the choice of multiple being subjective, the overall approach has fewer assumptions than calculating the intrinsic value and can better capture the mood of the market. When the assumptions can be robustly approximated, a discounted cash flow analysis can justify the equity value more precisely and account for different growth rates in a multistage model. In practice, buyers will often use a blended approach to enable them to approximate the company’s value.

What is equity value?

To put it plainly, to calculate equity value a business owner must take their company’s value, deduct its debt, add its cash, and then further deduct the deficit in net working capital or add the surplus. The reality is that this process will involve intricate calculations and can be more complex than it first appears. In order to help complete this, it is important to consult and work with advisory, accounting, and legal teams to clarify what falls under cash, debt, and working capital. Which brings us to…

Cash and debt

As discussed, the final sum a seller receives for their equity is affected by the cash, debt, and working capital which they have. The majority of M&A deals see transactions made on a cash-free, debt-free basis, subject to a standard level of working capital.

An example business acquisition case study can help show how this works in practice. If a business owner has £100 in the company bank account and an enterprise value of £50, the preference is naturally to sell for the full £150 rather than just £50. Conversely, if that company also had a £25 debt to the bank, the buyer would likely ask for a deduction, as they would be inheriting this obligation – similar to concerns around selling a house with a mortgage.

Working capital peg

Moving now to net working capital – which in the context of mergers and acquisitions is defined as current assets minus current liabilities, excluding cash (in wider accounting, cash is typically included).

This metric reflects short-term operational liquidity and shows the difference between current assets and liabilities which are expected to impact cash flow in the near future. This directly relates to the cash tied up in receivables and cash effectively advanced by suppliers depending on their standard payment terms.

To determine a net working capital target (the peg), cyclical fluctuations must be accounted for. Usually this is based on a 12-month average, but in particularly fast-growth cases, 6-months back and 6-months projected is sometimes used instead.

The amount taken off or added to the enterprise value is governed by the difference between actual net working capital at completion and the agreed peg. A deficit would lead a buyer to seek a deduction, while a surplus would require a buyer to pay for the excess. The intended end result is that the company leaves behind sufficient cash for business to continue as normal.

The importance of EBITDA

It is essential to be able to evaluate companies using comparable metrics. EBITDA is a tool which enables this like-for-like comparison – it serves as proxy for a company’s cash-generating ability, removing some standard non-cash items from any reported profits.

It is important to note, though, that EBITDA is not the same as cash flow, and in this respect there are other considerations to bear in mind such as debt repayments, capital expenditures, and working capital requirements.

To increase the specificity of the EBITDA metric and to tailor to the particular context of a valuation, alterations can be made to disregard non-recurring, exceptional income or costs. These could include a terminated division of the business or owner renumeration. This would provide a clearer understanding of the normalised EBITDA.

Attracting a buyer

The strategic reasoning behind an acquirer’s intended purchase will determine which businesses appeal to them or not. For instance, are they looking to buy a business as part of geographic expansion, product diversification, or in a bid to gain a competitive edge?

To try and appeal broadly to acquirers, though, typical advice for business owners would be to optimise their business model, bolster their standing in the market, and improve their operational productivity. Beyond this, it is also important to boost the ‘quality’ of earnings, prioritising expansion, recurring revenues, stability, and diversification. A strong growth rate, robust cash flows, along with minimal debt, is a sure way to strengthen a business’s appeal to prospective buyers.