Business Valuation Methods

The following is a brief description of the most common valuation methods used for valuing small to medium sized private businesses.

One or more of these methods are used depending on the nature and size of the business.

Method 1: Asset Based
This method focuses on the assets net of the liabilities. It does not take into account the profitability of the business and is the most appropriate method for under performing businesses, new businesses or any business where the sale of the assets outweigh the sale of the business as a going concern.

Method 2: Capitalised Future Earnings
With this method the value of the business is determined by the future profits that the business will generate for its owners. For most private businesses, Capitalised Future Earnings is the valuation method of choice and takes into account the Adjusted Profits and Return On Investment.

Before looking at this method, we should clarify the basis for which a Return on Investment is calculated. The Return on Investment (ROI) relies on the level of internal and external risks associated with a business, and assumes that the lower the risk, the lower the ROI, and resultantly the greater the value of the business. As investments go, businesses are generally considered riskier than government bonds, property and shares. As a result the lowest ROI achievable is approximately 20%. Beyond that figure an ROI of between 20% and 100% is calculated based on several risk factors that may be associated with the business.

For example, if someone who owns and manages his or her own business decides to sell it, a buyer could see the business as being too heavily reliant on that person. They would be right to ask questions like; how will the business be affected if the current owner leaves? This represents a high risk and as such the ROI will be considerably higher than if somebody else was managing the business.

Now that we understand the concept of how the ROI is established, the following equation should make more sense. Essentially, by dividing the businesses adjusted profits by the ROI we come to the price of the business.

Adjusted Profit / Return of Investment (%) = Business Price

An owner manager wants to sell their business, but a new manager will be employed when the business is sold. The following table serves to calculate the Adjusted Profits.

  2012 2013 2014
Sales $1,000,000  $1,200,000  $1,400,000 
Cost of goods $750,000 $900,000 $1,050,000  
Gross profit = $250,000 = $300,000 = $350,000
Expenses $200,000 $220,000 $250,000
Other expenses $5,000 $10,000 $15,000
Net Profit = $45,000 = $70,000 = $85,000
Interest on Loan     $25,000 
Owners wage and benefits      $130,000  
New managers wage     -$110,000   
Total Addbacks     $45,000   
Total Adjusted profits     =$130,000    
$130,000/ 33% = $130,000.00
Adjusted Profit ROI = Business Price

Although the profits are easy to calculate, hard science, art and a lot of experience is required to determine the most appropriate ROI. 

Method 3: Market Based
This method relies heavily on the recent sale of similar businesses. For example, the owner of business A wants to sell her hair salon. In her area, two other salon businesses have sold for 2.5 times and 2.2 times their adjusted profits in the last year. Based on this information the valuer will analyse the characteristics of both businesses and compare them to business A in order to determine the profit multiplier to be used.

It is commonly accepted that this method if done properly is the most persuasive and accurate for small and micro businesses. The downfall of this method is that market based information, due to the confidential nature of business sales, is sometimes hard to obtain.

Whichever Valuation method used, market sales history is usually taken into account. Comparable sales is the most trustworthy element of a good valuation. Remember; the market is the market. When it comes down it, chances are, the valuation you receive will involve elements of all of the above methods resulting in the truest opinion as to the value of your business.

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