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Business Valuation

Valuing a business

Learn the different techniques you can use to value a business before you commit to buying it.

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.

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Business Valuation Definition

What Is a Business Valuation?

A business valuation is a general process of determining the economic value of a whole business or company unit. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings. Owners will often turn to professional business evaluators for an objective estimate of the value of the business.

Estimating the fair value of a business is an art and a science; there are several formal models that can be used, but choosing the right one and then the appropriate inputs can be somewhat subjective.

Key Takeaways

  • Business valuation is the general process of determining the economic value of a whole business or company unit.
  • Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings.
  • Several methods of valuing a business exist, such as looking at its market cap, earnings multipliers, or book value, among others.

The Basics of Business Valuation

The topic of business valuation is frequently discussed in corporate finance. Business valuation is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business.

A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons.

Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of shares of a company will be taxed depending on valuation.

Special Considerations: Methods of Valuation

There are numerous ways a company can be valued. You’ll learn about several of these methods below.

1. Market Capitalization

Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded at $86.35. With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.

3. Earnings Multiplier

Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for current interest rates.

4. Discounted Cash Flow (DCF) Method

This method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value.

5. Book Value

This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets.

6. Liquidation Value

This is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today.

This is by no means an exhaustive list of the business valuation methods in use today. Other methods include replacement value, breakup value, asset-based valuation and still many more.

Accreditation in Business Valuation

In the U.S., Accredited in Business Valuation (ABV) is a professional designation awarded to accountants such as CPAs who specialize in calculating the value of businesses. The ABV certification is overseen by the American Institute of Certified Public Accountants (AICPA) and requires candidates to complete an application process, pass an exam, meet minimum Business Experience and Education requirements, and pay a credential fee (as of 2018, the annual fee for the ABV Credential was $380).

Maintaining the ABV credential also requires those who hold the certification to meet minimum standards for work experience and lifelong learning. Successful applicants earn the right to use the ABV designation with their names, which can improve job opportunities, professional reputation and pay. In Canada, Chartered Business Valuator (CBV) is a professional designation for business valuation specialists. It is offered by the Canadian Institute of Chartered Business Valuators (CICBV).

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