How much is it worth?

Although there are several formulas you can use, there are no black-and-white answers on valuation techniques. Conduct your own research, then get independent advice from a business valuer or broker.

By using several valuation methods and comparing numbers, you can cross-check your calculations and get a better idea of your business’ value. Here are four of the most commonly used methods.

• Method 1: Asset valuation
• Method 2: Capitalised future earnings
• Method 3: Earnings multiple
• Method 4: Comparable sales

 

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 the value of your business if it were closed down today and its assets sold off, but doesn’t take into account the ability of those assets to generate future revenue. For that reason, it may understate the true value of the business.

How it works

1. Add up the value of all the assets such as cash, stock, plant and equipment, and receivables.
2. Add up liabilities, such as any bank debts and payments due.
3. Subtract the business’ liabilities from its assets to get the net asset value.

 

Example
Richard wants to buy a manufacturing business with 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 it 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 of determining its value.

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Method 2: Capitalised future earnings
When you sell a business, you’re selling not only its assets but also the right to all profits the 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) a buyer can expect to get from the business.

How it works

1. Work out the average net profit of the business over the last three years using its profit-and-loss statements. Adjust the profit for any one-off expenses or other irregular items each year.
2. Decide on the annual rate of return a buyer might be looking for. There are no hard and fast rules about the number to choose, except higher risk should give higher returns. Compare the business with other investment opportunities — from safe havens like term deposits, to riskier investments like shares. Also look at the rate of return that similar businesses in the same industry achieve.
3. 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
This method is often used to assess the value of companies whose shares are traded on a stock exchange and reflect market expectations. But it can also be used to value unlisted businesses.

Its big advantage is its simplicity. The difficulty lies in deciding which multiple to use.

How it works
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.

 

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 relevant industry magazines, newspapers or websites.

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•  Important information
  As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on the advice, consider its appropriateness to your circumstances. All products mentioned on this web page are issued by the Commonwealth Bank of Australia; view our Financial Services Guide (PDF 59kb).