How we value a business
We assess businesses based on their intrinsic value.
Intrinsic value can be calculated by asking the following question:
If the business was trying to buy itself, how much could it afford to pay without damaging its ability to operate?
The answer to that question normally gets us very close to the intrinsic value of the business.
We answer that question by looking at each business in two parts.
Part one is the balance sheet (net assets).
Part two is the operating business (annual net profits).
Balance sheet value is determined by calculating how much it would cost to purchase each asset separately, today.
The valuation of the operating business is calculated by multiplying the average annual net profit.
Historically, the multiple factor applied to the largest businesses in the UK (FTSE 100) averages around 15.
This means that the cost of buying the UKs biggest businesses is around 15 times their annual net profit.
For SME businesses the average multiple is commonly between 1-5.
A multi-billion pound business stands a good chance of existing in 15 years and beyond.
A multiple of 15 reflects that.
Smaller businesses have a less certain long term outlook. The multiple is discounted to reflect that uncertainty.
Of course, the exact multiple is negotiated, but this is the foundation we use for our valuations.
Business autonomy is another critical component to our valuation process.
The more autonomous the team, the higher the value.
In practice, this means that the core functions of the business continue to run without daily owner input.
Generating new customers > Delivering the product to customers > Providing customers with ongoing product support.
The less input the owner provides to these core functions, the higher the value.
We also value products that can be integrated into an existing business.
The most important ingredient is the motivation of the business owner.
We work with owners that desire a sale primarily.
The idea of selling a business can be strangely compelling.
This attracts owners that are curious about selling, but only if the price far exceeds the intrinsic value of the business.
They don’t fundamentally desire a sale but they would sell if they received an astronomical price.
These types of valuations make little sense from an investors perspective.
FUTURE BUSINESS POTENTIAL
One of the most common justifications for a valuation that is higher than the intrinsic value is the future potential.
Very often an owner will point to specific growth opportunities that the business could take advantage of later.
If there is a way to ensure these future opportunities come to fruition then we are always happy to negotiate a higher valuation to reflect it.