What's it worth, guv?

Mergers and takeovers have become common in the industry, so suppose you get a call from a third party that is interested in buying your business. The prospective buyer may have a rough idea of how much it is prepared to pay, but do you know what your business is worth?

In reality, there is no correct price for a business. It is a matter of subjective judgement and negotiation – but it is essential to know the principles of business valuation.

The potential sale of a business is just one of several events that precipitate a valuation. Most firms need to be valued at some stage – perhaps the owners of a business wish to sell up, or an existing shareholder or partner wants to retire. Valuations may also be required on the death or divorce of an owner for tax purposes.

So how would a fair value be established? In practice, both parties in a sale would arrange independent valuations. The following three approaches are the most common and can be used together or in isolation. These focus on valuing a limited company, but the principles can be applied when valuing a partnership.

Earnings yield is the most widely used approach when valuing a medium-sized company as a going concern. It involves determining a level of "maintainable earnings", which take into account past and future earnings. Maintainable earnings do not necessarily equate to net profit in the company's profit and loss account. Adjustments are made for abnormal items unlikely to recur in the future, such as excessive or below market rate remuneration for directors or family members and some non-cash flow items such as goodwill.

Next, the yield or fair return that investors would expect for their investment needs to be determined. This is achieved by looking at the price/earnings (p/e) ratios of similar quoted companies. Company p/e ratios are published in the Financial Times each day. However, these ratios are for companies in which the shares are traded on the stock market. The buyer of a smaller unquoted business would also have to consider the additional risks and rewards of his investment. For instance, if the p/e ratio of a group of quoted companies similar to yours is 12, then the purchaser of your business may discount this figure significantly when considering the risks. Alternatively, if industry data is available, a direct comparison to similar unquoted businesses may be possible. So a simple calculation of maintainable earnings multiplied by the p/e ratio gives the valuation of the company.

The valuation of a business is not an exact science, so different valuers are likely to come up with different figures for the same business

Net asset value of a company is derived from revaluing the assets and liabilities to current market value on the balance sheet. This method is used when a company is being broken up or assets stripped out, because it ignores the value of any goodwill in the business, were it to continue trading. For instance, where a company owns a land bank or property, its value may be more accurately calculated by looking at the current or potential value of the assets rather than at its trading performance.

A net asset valuation is often prepared along with the earnings yield method as a comparison to ensure that the value of a company determined by this method is at least equal to the break up net asset value.

Dividend yield method is only relevant when valuing a minority shareholding where there is a consistent dividend history. It can also be used where the company operates an employee share scheme. Many factors affect the dividend paid by a typical medium-sized company, such as the business' cash flow needs or the shareholders' tax planning needs. After determining the maintainable dividend and the fair dividend yield, the mechanics of valuing a business on this basis are the same as the earnings yield basis.

The valuation of a business is not an exact science, so different valuers are likely to come up with different figures for the same business.