How to value a business

Valuing a business involves many assumptions and can quickly get complicated. In this article, I will attempt to explain how you can easily do this.

Perhaps the easiest value to use is the book value of the business which is simply the value of the assets less the liabilities. Basically, you add up all the company’s assets including; property plant and equipment, inventories, receivables, investments, cash, etc. and you deduct any loans and liabilities. If the business has proper books of accounts this figure will show up as the net assets or equity on the balance sheet. The book value of the business is just a baseline figure and is based on historical costs which don’t take into consideration the future prospects of the business. 

Now that we have determined the historical value of a business we need to evaluate the future prospects or market value of the business. This is easier said than done. If the business is a listed company we simply look at the share price and multiply it by the number of shares. What we get is a so-called market capitalization. In many cases, the market capitalization is very different from the book value. The share price is determined by the market forces of supply and demand including market sentiment. A good business may be ignored by the market which would make its share price trade below book value. Such market distortions can present good bargains for the shrewd investor. 

If the business is not listed we need to try and estimate the future cash flows and then discount them back using an appropriate rate. So let’s say you have a small business that generates ugx 10m in profits every year. We can estimate the value of this business by dividing the annual net cash flows by an average discount rate of 10% (which is the average interest rate on a unit trust). In this case, we end up with a value of ugx 100m (10m divided by 0.1 or 10%). To account for growth we use a modified discount factor which is the nominal discount rate with the growth element deducted. So if annual cash flows are expected to grow at 3% then the new intrinsic value estimate is ugx 143m (ugx 10m divided by 7% or (10% – 3%)). The figure we get is often called the intrinsic value of the business and represents the real worth of your business.

Another estimate of market value is the replacement cost of the business. Basically, how much would an independent person spend to rebuild the business in its current form? This would mean revaluing all assets and liabilities at current market prices including any accumulated experiences and goodwill.

Now the question is how much would you sell your business for? The valuation methods I have shared are just indicative. The book value is a historical figure. The share price represents market sentiment. The intrinsic value takes account of future prospects. The replacement cost is the price to rebuild the business. Ideally, you should sell above book value and as close as possible to intrinsic value. However, the final price will depend on the surrounding circumstances and other market forces. Your business may be valuable but if there is no willing buyer the price will remain depressed.

I hope this simplified article has given you a rough idea of how to value your business. So don’t be so impressed by your friend’s seemingly big prosperous business. Simply ask them what the book value and intrinsic value of the business are? If they fumble in their seats, just smile and point them to this article.