Although there are several formulas you can use, there are no
black-and-white answers on valuation techniques.
It’s important to conduct your own research, then get independent advice
from a business valuer or broker. Here are four of the most commonly used
valuation methods.
Method 1: Asset valuation
The value of a business is determined by adding up the value of its assets
and subtracting liabilities. It tells you what the business would be worth if
it were closed down today and its assets sold off, but it doesn’t take into
account the ability of those assets to generate revenue in the future. For that
reason, it may understate the true value of the business.
How it works
- Add up the value of all the assets such as cash, stock, plant and equipment
and receivables.
- Add up liabilities, such as any bank debts and payments due.
- Subtract the business’ liabilities from its assets to get the net asset
value.
Example
Richard wants to buy a manufacturing business. Here’s an extract from the
business’ balance sheet.
If the business has assets of $300,000 and liabilities of $200,000, the net
asset value of the business is $100,000.
What about goodwill?
This method doesn’t include a value for goodwill, so may understate the
true value of a business. Goodwill is the difference between the true value of
a business and the value of its net assets. It can be crucial to the value of
retail and service-based businesses.
For example, if you value a business such as a hairdressing salon, where
service, location and reputation are important, the value of any goodwill would
have to be added to net assets to get a valuation.
Can goodwill be transferred if you buy a business? It can come from physical
features such as location, or from personal factors, like the owner’s
reputation or their relationships with customers or suppliers, which may not be
transferable.
If the business is underperforming and has no goodwill, then using the net
assets valuation method could be an accurate way to value it.
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Method 2: Capitalised future
earnings
When you buy a business, you’re not only buying its assets but also the
right to all profits that business might generate.
Capitalising future earnings is the most common method used to value small
businesses. The method looks at the rate of return on investment (ROI) that you
can expect to get from the business.
How it works
- Work out the average net profit of the business over the last three years
using its profit-and-loss statements, adjusting profit for one-off expenses or
other irregular items each year.
- Decide the annual rate of return you’re looking for (e.g. 20%). There are
no rules about the number you choose, except higher risk should give higher
returns. Compare the business with other investment opportunities. You can also
look at the rate of return that similar businesses in your industry
achieve.
- Divide net profits by the rate of return to determine the value of the
business, then multiply by 100.
Example
David is looking at buying a bakery business with average net profits of
$100,000 per annum after adjustments. David wants an annual rate of return of
20%. The capitalised earnings valuation is:
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Method 3: Earnings multiple
Multiply the business’ earnings before interest and tax (EBIT) by your
selected multiple. For example, you might value the business at twice its
annual earnings — so a business with an EBIT of $200,000 might be valued at
$400,000.
The multiple you choose will depend on the industry and the growth potential
of the business. A service-based business might be valued at as little as one
year’s earnings, while an established business with sustainable profits might
sell for as much as six times earnings.
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Method 4: Comparable sales
Whatever other valuation method you use, you should also look at prices for
recent sales of similar businesses. It makes sense to know what is happening in
the market you’re interested in.
Speak to business brokers and gauge their feeling about the business’ value.
They might know what similar operations are selling for and how the market is
placed. Check business-for-sale listings in industry magazines, newspapers or
websites.
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