How to value a business  

There are many different methods used to value a business.  

These are the four most commonly used methods of valuing a business. The type of business that you are considering selling, or buying, will determine which method will work best for you.   The four methods are:  

Profit based Valuation  
Most businesses are valued this way when there is enough profit to do so.  

Asset Based Valuation  
This method is generally used when

• The buyer is only interested in the assets of the business, and is not taking over as a going concern.
• The business is being split up and the assets are being sold separately.
• The business has no goodwill. The business is going into liquidation.  

Rule of thumb  
This method is widely used in business types that have a certain figure on which value is placed when compared to another figure, for example Sales/Gross Profit or number of clients/customers.  

Comparable Sales Method  
This method is used to value a business based on similar recent sales of businesses which are almost identical in regard to location, business type, sales etc.  

Before considering any of the methods in more detail it is important that you have a good understanding of “add backs” or “normalization” of accounts. If these terms mean nothing to you it will be worth reading our page on Adjusting Financial Figures.   Assuming that you are familiar with the normal presentation of business accounts let us now look at each of the above valuation methods in more detail.  

Profit Based Valuation.  
The quick and easy method.  
This method is widely accepted when valuing smaller businesses where the profit is usually no more than the business owners wage. In this situation the buyer is normally just “buying a job” The value is calculated as follows: 
 
Value = Plant and Equipment + Annual Net Profit before deductions of Interest, tax, depreciation, and salary of the owner.  

This is a method which will not work for a larger business, when there is substantial profit. In this case there will need to be calculations made for return on investment.  

When using the quick method there is not too much importance placed on the wages of the owner because they are part of the overall profit. When looking at larger businesses the owners wage will be deducted before putting a figure on overall profitability of the company.  

Discounted Cash Flow Valuation.  
This method works on the assumption that the value of the business is based on the future net cash flow. When these calculations are made they will normally be discounted back to the present rate.  

This method is used frequently in the mining industry and other businesses where there are measurable future revenue sources (usually determined by a contract)  

This is probably one of the most complex forms of  valuation, if you have a business that is to be sold in this way it will be crucial to take professional advice.  

Capitalisation of Future Maintainable Earnings (CFME)  
This method is one of the most widely used, most accountants favour this way of valuing a business. When using this method each dollar of profit can mean between two and five dollars in value. In order to come up with the accurate value, or selling price this method aims to place a figure on future profits and then apply a multiplier to that profit. It is important to remember that the multiplier must be applied to the true profit which means that the wages of the owner must be deducted.  

Asset Value methods  
Assets Only
This method places the lowest value on the assets of the business. The assumption when using this method is that in the worst case scenario the buyer could liquidate the assets without sustaining a loss.  
There is no goodwill in this method and the value will be largely dependant on the offers that are put forward from interested parties. There can be some guidance taken from the asset register and book value of the assets but when using this method the old saying that “it is only worth what someone is prepared to pay for it” definitely rings true.  

Assets valued by the going concern value  
In this method there is no payment for goodwill. A value is placed by assuming that the purchase of the assets will enable the buyer to operate the business for its intended use, and generate profits of a similar previous level. Value is calculated on the book value of all plant, machinery, fixtures and fittings, and stock.  

Depreciation Value  
This is taken from the balance sheet of the vendors accounts. The deprecation period will be determined by the type and value of the purchase and will be applied annually. The carried forward balance of all equipment will be depreciated at the end of each year. If you sell you business part way through a financial year you must remember to depreciate the assets for that period. It is also very important to consider that tax will be payable if you sell the fixtures and fittings for a greater value than on the balance sheet.  

Replacement Value  
This is the cost of replacing existing equipment with a secondhand equivalent. If it is not possible to find a comparative in the secondhand market the new price should be adjusted by the appropriate level of depreciation.  

Comparable Sales Method
This method is used by valuers, usually in conjunction with one of the theoretical methods. This way of placing a value on a business will only be able to be used if you have sufficient accurate data. Most valuers will seek the advice of business brokers when using this method. By speaking with the brokers they will be able to establish recent selling prices of similar businesses. The difficulty with this style of valuation is that no two businesses are the same, for this reason it should really be used as confirmation that the initial theory based valuation is correct.  

If you consider using this method to value your own business you must be careful not to assume current market value. Many people make the mistake of looking through business for sale listings, picking out similar businesses and assuming that theirs must be worth the same. It is crucial to remember that this is not a reflection of current market value but merely a reflection of what other business owners feel that their businesses are worth. You would be well advised to speak to a few brokers and gauge their feeling for the value. They will know what similar businesses are selling for, and how the market is at that particular time. 

The rule of thumb method  
This is the least used method of valuation it does however have its use for certain types of businesses. Value is calculated by applying an industry multiplier to the gross sales, or the gross profit of the business. This is accepted by the respective industry because cost structures are commonly definable. This method is also applied when the business is being sold to another business in the same trade.This is because certain cost elements can be adsorbed by the purchaser and the purchaser will be able to benefit from economies of scale. These types of sales are known as trade sales or synergistic sales.  

If using this method it is important to remember that any form of valuation that involves applying a multiplier to industry norms is risky in a fluctuating market. As with the previous methods it is vital to be aware of the current market situation for your particular business or industry.  

Businesses which are typically valued using this method are:

• Retail Butchers
• Legal Practices
•  Real Estate offices
• Newsagencies
• Taxis
• Milk Runs
• Medical Centres
• Accountancy Practices
• Service Stations 

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