How to value a business before selling: net assets, EBITDA multiple and DCF explained

How much is your business worth, what do buyers actually find valuable, and what can you do to improve your valuation before you sell? There is no single answer, because there are three main ways to value a business and each one rewards different things. This guide covers the asset-based method, the earnings multiplier (or EBITDA multiple), and the discounted cash flow method, and for each one what a seller can do to push the number up.

Asset-based business valuation (net assets)

The asset-based method is the simplest of the three. You take the value of the company's assets, deduct its liabilities, and the figure you are left with is the valuation. It is also referred to as the net asset value method.

This method is typically used for asset-heavy businesses. Real estate companies and intellectual property holding companies are the obvious examples: the value sits in what the company owns rather than in the trading it does. The business may trade as well, but if what a buyer is really paying for is the property or the portfolio of rights, the net asset figure is the natural starting point. Buyers use the same approach when they want to check that the balance sheet they are paying for actually exists.

Improving a valuation under this method is straightforward, because the formula only has two inputs.

• Increase the value of the assets. If the asset is real estate, that might mean reinvesting in the property and refurbishing it so that it is worth more on the day of the sale.
• Pay down liabilities. If the liabilities are mortgages, try to reduce them. Every pound of debt you clear is a pound added to the net asset value, and it also makes the balance sheet easier for a buyer to understand.

EBITDA multiple valuation method

The earnings multiplier is the most common way to value a trading business. It uses your EBITDA, which is earnings before interest, taxes, depreciation and amortisation, and applies a multiple based on the standard for your industry.

In plain terms, we look at how much money, or cash flow, the business is generating, and we multiply it. If the industry standard multiple is three, we multiply EBITDA by three, and that is the business valuation.

This method is typically used where there is a stable and profitable business in an established market. The reason it works is that the EBITDA is reliable. We can look at what the business has been producing, we expect it to stay roughly the same, and so a multiple of that figure is a sensible basis for a price.

There are two ways to improve your valuation under this method.

• Argue for a higher multiple. The multiple is not fixed by law. You can try to persuade the buyer that a higher multiple should apply to your business, and you will need a reason: the stability of the revenue, the quality of the client base, the position in the market, or whatever genuinely sets you apart.
• Increase the EBITDA. For example, for a period before the sale, stop running costs through the business that you might typically have put through it but that the business does not actually need. Every pound of unnecessary cost you remove increases EBITDA, and that increase is then multiplied.

Of the two, the multiple is where the bigger swings happen. Moving a business from a multiple of three to a multiple of four adds a third to the price, so it is worth building the case properly and well before you start talking to buyers.

Discounted cash flow (DCF) valuation

The discounted cash flow method tries to estimate the future cash flow of a business, typically on an EBITDA basis as discussed above, and then discounts those future earnings back to present value.

What does that mean, and why do we do it? The idea is that money in the future is worth less than the same money now. If the business is going to make £3 over three years, those £3 in three years' time are worth less than £3 today. So a buyer should not pay £3 today in the hope of receiving £3 in three years. Part of the reason money is worth less tomorrow is inflation. That is why we look at future earnings and discount them back to today's value.

This method is typically used for high-growth companies with fairly predictable revenue, where the historic EBITDA understates what the business is about to become. A multiple of last year's profit would undervalue a business that is doubling, so the buyer looks forward instead and prices what is coming, with a discount for the wait and for the risk that it does not arrive.

You can improve a valuation under this method by justifying to the buyer why you believe future revenue will be even greater than they expect. The bigger the future earnings you can credibly support, the bigger the figure that gets discounted back, and the higher the valuation.

Terminal value

When it comes to discounted cash flow, there are two main values to think about.

• Earnings over the forecast period. First is simply the earnings the business is expected to generate over a period of time, say three years. In my experience that period often coincides with the deferred payment period in the deal. If the buyer is going to pay the seller over three years, then typically we look at earnings over three years and discount them back.
• Terminal value. After those three years are over and the seller has been paid off, there is still residual value in the business. Businesses are expected to go on indefinitely unless something says otherwise, so there is still value at the end of the forecast period. That is what is referred to as the terminal value.

As a seller, you will want to argue that the terminal value should be given more weight, and that it should be bigger. It is easy for a buyer to focus on the three-year forecast and treat everything after it as an afterthought, which quietly leaves a large part of the value out of the price. If the business will still be trading and generating cash in year four and beyond, that value is yours to negotiate for.

Which valuation method applies to your business?

The method a buyer uses will usually follow the nature of the business. Asset-heavy companies tend to be valued on net assets. Stable, profitable trading businesses in established markets tend to be valued on an EBITDA multiple. High-growth businesses with predictable revenue tend to be valued on discounted cash flow. In practice a buyer may run more than one method and compare the results, so it helps to understand all three and to know which inputs you can influence before you go to market. The common thread in every method is that the valuation is an argument, not a fact. The seller who turns up with evidence for their assets, their EBITDA, their multiple or their future cash flow is the one who gets closer to the number they want.

Next steps

Work out which valuation method a buyer is most likely to apply to your business, then focus on the inputs that matter for that method: asset values and liabilities, EBITDA and the multiple, or future cash flow and terminal value. Speak to an accountant and a corporate solicitor before you open negotiations so that the valuation case, and the deal structure that goes with it, are ready before a buyer puts a number on the table.