Valuing a Business
So, what do you think it’s worth?
The very first question I receive after agreeing on contract specifics.
“So how much do you think we can get”
The truth is there is no sure-fire way to value a business for buying and selling purposes. The true value is the perceived value to a buyer who is ready, willing, and able to buy it.
Business valuation is a mix of art and science. The goal is to find a fair price that satisfies the seller and is in line with the current market.
There are several reasons for valuing a business. Businesses are valued for estate and tax purposes, divorce settlements, and for raising capital. For these needs I would strongly recommend engaging a registered valuer.
Valuation discussions in this article are purely for the purpose of buying or selling a business.
- Quick Estimate
- Market Average
- Capitalised Earning
- Excess Earning
- Cash Flow.
- Tangible Assets/Cost to Create.
- Intangible Assets
1. Quick Estimate
Often used as a guide to the valuation of a small business. It is only a useful starting point as few buyers will pay one year’s earnings before proprietor’s drawings, interest, tax and depreciation (EBPITD).
Useful for strong branded businesses with a real goodwill factor and transferable long-term contracts. Can also be used for a national franchise or business with high demand
Price of Business = (Plant & equipment + 1 year’s EBPITD.) plus Stock at
Business which handles a national product and has an exclusive distributorship, produces $100,000 Net Profit (earnings before proprietor’s drawings, interest, tax and depreciation (EBPITD). The plant and equipment are valued at $150,000. The stock on hand cost $60,000. The distributorship is transferable.
Price of Business = $100,000 + $150,000 = $250,000 plus S.A.V $60,000 = total price $310,000
2. Market Average
One of the most common approaches to small business valuation, that I see a lot of brokers use.
The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of their type.
You may take statistics for 2 years across 100 lotto shops. Then average the selling price and you have a market average selling price.
However, some of those lotto shops may have sold for twice the market value while others were a quarter of the norm.
We are also aware there can be great variations over a year, particularly if there was an anomaly in one of the years (Covid prices).
In a lot of cases the average is done with nothing more statistical than
“Other like businesses in your area are selling for this”
Market averages may be accurate for those businesses whose performances are on par with the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with market averages.
Market averages are a good starting point for valuation. Check to see how closely your firm’s financial performance stacks up to the market averages.
3. Capitalised Earning
Capitalisation refers to the return on investment that is expected by an investor.
The capitalisation rate is determined by learning what the risk of investment in the business would be in comparison to other investments
Capitalisation rates of 20% to 50% are common for a small business calculation. That is, buyers will look for a return on their investment of 10% to 50% (depending on risk) in buying a business after a suitable wage is deducted from the EBPITD.
Best for valuation of businesses that have fixed assets with low wage impact.
A vending machine has been collecting money at the rate of about $86,500 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely.
At the 20% low risk rate, for someone to earn the same $86,500 per year the vending machine earns, an investment of $432,500 ($432,500*20%=$86,500) would be required. Therefore, the amusement machine business value is in the area of $432,500.
This does not include a fair salary for the new business owner
Let’s assume a $30,000 salary to manage the machine.
$86,500 Net Profit (earnings before proprietor’s drawings, interest, tax and
$30,000 Wage depreciation (EBPITD)).
$56,500 divided by 20% = $282,500 being the business value
4. Excess Earning
Like the capitalisation method. The difference is that it splits off return on assets from other earnings.
Let’s assume a vending company has tangible assets of $120,000.
The owner takes $30,000pa as salary
After paying the salary of $30,000 from his $86,500 net (EBPITD) The business has earnings of $56,500 net.
Assume a reasonable return on Tangible Assets of 15% per year
A reasonable number here should be based on industry averages for return on assets adjusted to current economic conditions.
Alternatively, an appropriate return on asset figure is to use a rate 3 to 4 points above the current bank rate for a small business loan, or about 6 points above the current prime rate.
Business profits are derived from the tangible assets of the business ($120,000 x 15%= $18,000) The other $38,500 ($56,500$18,000=$38,500) in earnings are the excess earnings).
This $38,500 excess earning number is typically multiplied by a factor of 2 to 5, based on such factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be
Assume the business is better than average in these factors and assign a multiplier of 4. Therefore, the value of this business can be determined as follows:
- Fair market value of tangible equipment (plant & equipment) Equals $120,000
- Total Earnings Equals $56,500
- Earnings attributed to Tangible Assets ($120,000*15%) Equals $18,000
- Excess Earnings (B – C) ($56,500 – $18,000 = $38,500)
- Value of excess earnings (D X multiplier) ($38,500 x 4) Equals $154,000
- Estimated Total Value (Tangible Assets plus value of excess earnings) Equals 120,000 + $154,000 = $274,000 Being the Business Value
5. Cash Flow.
Ideal in valuing online businesses that have no real equipment nor stock overhead but generates revenue through no asset sales.
Businesses can be evaluated by determining how much of a loan the net profit will support. That is, they will look at the net profit (EBPITD)) and subtract from this net profit an estimated annual amount for equipment replacement. They will also adjust the net profit by subtracting a fair salary or at least an acceptable salary for the new owner.
The adjusted net profit number is used as a benchmark to measure the firm’s ability to service debt. If the adjusted cash flow is, for example, $100,000 and prevailing interest rates are 10%, and the buyer wants to amortize the loan over 5 years, the maximum a buyer is willing to pay for the firm would be about $253,000. This is the loan payment that $100,000 would support over 5 years.
6. Tangible Assets/Cost to create
Used when a business is worth no more than the value of its tangible assets. This would be the case for some businesses that are losing money or paying the owner’s less than fair market compensation.
Valued at the best possible price for the asset list. Also take into consideration any leasehold renovations you have done.
When buyers do an evaluation, they should consider the costs to create what you already have in place and buy accordingly.
Very applicable to restaurants and cafés, where the general fit out costs can run as high as $250,00 before you open the doors.
Unfortunately, it is very rare you will recoup all these initial costs but need to be factored into your sell price.
When selling a software business, many buyers will purchase the licenses and copyrights as the time to develop themselves can take years or not at all.
They will buy the business based on their projected costs
7. Intangible Assets
Based upon the buyer’s buying a wanted intangible asset versus creating it. Many times, buying can be a cost efficient and time saving alternative.
Commonly used in the acquisition of a customer base. Customers with a high likelihood of being retained are valuable in most industries.
Consider an accounting firm with a $100,000pa turnover.
No. of clients, client break up:
- SMSF -1
- Trusts -11
- Partnerships -3
- Business -44
- Individuals –284
Because of the large individual customer ratio, the value may only be 70% of the total revenue.
An increase in SMSF or business can increase this value to 100% of the turnover
Primarily businesses that are bought and sold for their customer base.
There is no golden bullet to valuing a business sales price.
The above is differing approaches to get an estimated value.
Ultimately if you can explain an in-depth approach to how the business value was decided, you will be in a much better place in achieving a satisfactory sale.