If you’re thinking about buying a business, you need to make sure you’re paying a fair price for it. These are four of the most commonly used business valuation methods.
Understanding them will help you with your own research and when you get independent advice from a business valuer or broker.
1. What is the asset valuation method?
This method tells you what the business would be worth if it closed down and was sold today, after all assets and liabilities were accounted for.
How it works:
Assets such as cash, stock, plant, equipment and receivables are added together. Liabilities, like bank debts and payments due, are then deducted from this amount. What’s left is the net asset value.
For example, Richard wants to buy a manufacturing business. It has $300,000 worth of assets and $200,000 of liabilities. Its net asset value is $100,000, so with the asset valuation method, this business is worth $100,000.
What about goodwill?
Goodwill is the difference between the true value of a business and the value of its net assets. Goodwill represents the features of a business that aren’t easily valued, such as location, reputation and business history. It’s not always transferred when you buy a business, since it can come from personal factors like the owner’s reputation or customer relationships.
The asset valuation method doesn’t take goodwill into account. If a business is underperforming and has no goodwill, then using net asset valuation could be an accurate way to value it.
2. What is the capitalised future earnings method?
This is the most common method used to value small businesses.
When you buy a business, you’re buying both its assets and the right to all profits it might generate in the future, which are known as future earnings. The future earnings are ‘capitalised’, or given an expected value. The capitalisation value gives the expected rate of return on investment (ROI), shown as a percentage or ratio. A higher ROI is a better result for the buyer.
The capitalised future earnings method lets you compare different businesses to work out which would give you the best ROI.
How it works:
- Work out the business’s average net profit for the past three years. Take into account whether there are any conditions that might make this figure hard to repeat
- Work out the expected ROI by dividing the business’s expected profit by its cost and turning it into a percentage
- Divide the business’s average net profit by the ROI and multiply it by 100. Use this figure as the value of the business
For example, David is considering buying a bakery with an average net profit of $100,000 after adjustments. He wants an ROI of 20%. He divides $100,000 by 20% and multiplies it by 100 to get a business value of $500,000.
3. What is the earnings multiple method?
This is a method that helps compare different businesses, where the earnings before interest and tax (EBIT) are multiplied to give a value. The ‘multiple’ can be industry specific or based on business size.
How it works:
- Find the earnings before interest and tax (EBIT) of the business
- Seek advice from a business valuer for an accurate business earnings multiple
- Multiply your EBIT by your multiple to find the business value
For example, Mary wants to buy a sporting goods store. It has an EBIT of $100,000 and an industry value of 2. This means she values it at $200,000.
4. What is the comparable sales method?
You can get a realistic idea of what you may need to pay for a business by checking out comparable sales. This is the price that similar businesses have sold for.
How it works:
Check out the sales of recent businesses in your industry and location. You can get this information from:
- Business brokers, who can also give you an idea about the value of the business you’re interested in
- Business sales listings in industry magazines, newspapers or websites
For example, Susan wants to buy a cafe. Recently, cafes in her location have sold for $150,000, so she knows this is a realistic value for a similar business.
For a detailed understanding of a business’s value, contact a business valuer or broker.