There are many reasons to want to know the value of your business. Raising investment or preparing to sell are two of the main drivers, but even if you have no intention of selling or making changes to the business and its ownership, having a clear valuation means you are in a strong position to understand and react to new business opportunities.
This article will explain how and why you might look to value a business using a profit formula.
What is a profit formula?
There are several ways to value a business, from using your balance sheet to subtract liabilities from assets, to using more complicated methods such as discounted cash flow. But one of the quickest calculations is to use a profit formula. A profit formula values a business based on an agreed multiple of its annual earnings, which means profit after tax.
The formula is:
Value = annual earnings x industry ratio
If a business has earnings of £500,000 and an industry ratio of 2, a buyer would be expected to pay £1 million for the business. Different industries and sectors have different 'typical' ratios, but it is always useful to have an expert look at your specific business and transactions for an accurate valuation, advises Mark Ridout, a valuation expert at RA Valuations.
Valuation ratios will be lower for businesses that tend to grow slowly, or where the rate of failure is high. For example, coal mining businesses tend to see a P/E ratio of around 3, since there is limited future growth potential in fossil fuels. Meanwhile, healthcare businesses can see valuation multiples as high as 50, because significant growth in need for such services is expected as the population ages.
Examples of common industries and typical earnings multiples
- Newspapers 0.9
- Soft drinks 1.7
- Mining 2.2
- Pharmaceutical 8.3
- Aircraft 4.79
- Real estate 10.2
It’s important to remember that these figures are just industry averages. Every business is unique, and there are a range of factors that might affect the multiple applied to your business, making it higher or lower than average (see below section on ways to maximise the value of your business).
Why use a profit formula to value your business?
A key reason to use a profit formula to value your business is that it allows companies to understand how their valuation compares with other businesses in the same sector. This can be useful when starting to pitch for external investment, or when benchmarking your performance, says Ridout.
Last year, founder and CEO of Champion Communications, Richard Cook, received two approaches from potential buyers for his business, both of whom had valued the company at more than the industry standard multiple. Initially surprised, after taking advice and looking at his company’s growth and profits, Cook realised his business had been growing at a faster rate than the industry average, and a string of industry awards in 2021 had raised the company’s profile and increased new business inquiries.
The company’s status also made it easier to attract and retain high-performing staff.
“I know that our reputation counts for a lot, and we have a very strong management team,” says Cook. “Those things, combined with the contracts we have in place with clients, all justified that higher valuation.”
Staff retention is vital to the health of a business, and its attractiveness to potential buyers. The American Express® Business Gold Card offers an easy way to show your appreciation to your valued staff, since for every £1 you spend, you’ll get Membership Rewards® points¹ that you can use on a wide range of perks and gifts for your team.
When not to use a profit formula to value your business
If your company is in negotiations for investment or setting up an employee share scheme, then the valuation needs to be more detailed, and based on actual transactions and your specific business model, says Ridout.
“The industry average ratio is a good starting point, but you might not have the same cost of goods, or the same profit margins or even business model as a competitor, so the formula might not be appropriate for your business,” he says.
Ways to maximise the value of your business
An expert valuer will look for elements of your business that could be used to justify a higher ratio. A simple tip, according to Ridout, is to think about the "kerb appeal" of your business. Just as you might paint your windows when selling a house, you need to present your business in its best light. If you’re a retail business, that might mean investing in new fittings, or for a manufacturing plant, investing in automation.
More importantly, Ridout advises business owners to focus on financial performance and profitability. "If the numbers aren’t right, your valuation will suffer," he says, suggesting that businesses look for ways to increase gross profit margin and sales, while reducing overheads.
Other factors that might impact the value of your business - both positively and negatively - are listed below.
Positive factors
- High rate of repeat business and predictable income: you can boost the valuation multiple of your business if a higher proportion of revenue (compared to other companies in the same industry) comes from repeat business, long-term contracts, and renewing subscriptions.
- Strong management team: if your company can function well without the current ownership team on site, then this suggests the business value won’t leave the moment you do.
- High growth: A company that is scalable and has high growth potential will always be more valuable than one with slower or declining growth. Having a plan to increase future growth will have a greater impact on your valuation multiple.
Negative factors
- High dependence on the owner and personal relationships: If you are the business owner and you’re the person who engages with new customers, negotiates new contracts and oversees operations, what happens when you leave? A new owner would need to spend a lot of money to replace you, then this will be reflected in your valuation.
- Volatility: Earnings that jump up, then fall back aren’t a good sign when valuing a company. Potential purchasers would apply a lower multiple if earnings have been unstable.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
- If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.