There are various ways to calculate the value of a business. Business sellers and buyers often use more than one method in negotiations to validate the valuations prior to finalising any transaction.
Business valuations are often undertaken by accountants or specialist company valuers. However, if you are buying or selling a business, understanding the mechanics of these valuation methods is important. There are four primary ways to determine the value of a company.
Capitalised future earnings
This is the most common form of valuation applied to small businesses. It assesses the rate of the return on investment (ROI) that a buyer of the business expects.
As the buyer of the business is purchasing the business assets plus the rights to all future profits, the rate at which the investment is returned is a primary consideration.
Capitalised future earnings are expressed as a percentage of the net profits. Net profits are taken from the previous three years profit-and-loss statements. This value is then divided by the rate of return expected by the potential buyer and multiplied by 100 to return a percentage value.
Possibly the simplest way to value a business is to determine the value of the assets and then subtract the liabilities. Assets may include cash, equipment and stock. Liabilities may include any debts, loan repayments or any other money owed.
Asset management valuations do not include goodwill of a business. If your business depends on service, location and its reputation, then these elements may be included when determining the true value of the business. Goodwill is commonly applied to retail or service-based businesses.
To determine the value of the goodwill of a business, subtract the net assets from the stated true value of the business.
Another simple way of valuing a business is to use the earnings multiple method. It is most often used for publically listed companies but can be applied to unlisted companies.
Simply take the earnings before interest and tax (EBIT) and multiply it by a number; the multiple. What that multiple is can be the subject of much debate and can vary across industries and business types. Service-based industries are often only valued at as little as one year’s earning; a multiple of one. An established business with proven, sustainable profits may sell for six times its earnings; or a multiple of six.
If you are looking to buy a business you should always consider the prices of recent sales of similar businesses. Even if there is a valuation based on one of the other methods, consider comparable sales to validate the values presented.
Whatever the method used to determine the value of your business or one you are considering buying, speak to business brokers, business valuers and your accountant to understand the method and the true meaning behind the valuation before making a decision.