There are four commonly used valuation methodologies used for a small businesss valuation:
- Future maintainable earnings
- Earnings multiple
- Comparable sales
- Asset Valuation
Future Maintainable Earnings
When you buy a business you are also buying the potential profits that it may generate in the future. Future maintainable earnings is the most common small business valuation methodology and looks at the adjusted earnings of a business and the rate of return buyers can expect from the business by capitalising it’s future earnings. Return on investment is the level of risk a purchaser is willing to take on the business based on a combination of macro and micro factors. Generally when people buy businesses they seek a 20% – 100% return on investment. How it works The future earnings of the business can be calculated by taking the average profit over the last three years adjusting for one off expenses any irregular payments. Now find the rate of return that you are willing to risk (i.e. 40%) Then divide net provide by the rate of return and then multiply by 100. E.g. a business makes $100,000 per year. You want a rate of return of 40% therefore you divide 100,000/40 = 2,500. Then multiply by 100 equals $250,000.
You may apply an earnings multiple to your business. For example take your EBIT (Earnings before interest and tax) and multiply it by 2. How It Works So for our business that is making $100,000 per year. We multiple that by our earnings multiple (2) and we get a valuation of $200,000. The multiple will be dependent on various factors including the net profit, industry, growth potential and other macro factors. Multiples can range from 0.5 to 6 depending on the business.
You may search for similar sales of your business to find comparable sales data. How It Works By looking at what other businesses similar to what yours sold for you can get a gauge of what your business is worth.
You may make your valuation based on the assets of the business. An asset valuation takes all the assets of the company and then subtracts liabilities. This method is normally used when the company is going to be shut down. How It Works
- Add up all the assets of the company including cash, stock, accounts receivable, buildings, land and plant and equipment.
- Add all liabilities including creditors, loans and all payments due.
- Subtract the total value of the liabilities from the total value of the assets to get the total asset value.
NOTE: good will is not included in an asset valuation. The assumption is the business will not be trading in the future.
- Discounted Cash Flow – this method is favoured by large accounting firms and is not normally appropriate for small and medium businesses. It attempts to put a value on future cash flows of the business.
- Return On Investment (ROI) – the ROI valuation method takes the current net profit and divides it by the expect rate of return.
- Price To Earnings Ratio (P/E) – this is the valuation method used to value public companies. The difference is the after tax profit is used as a multiple in earnings. What business owners fail to recognise is that a P/E of say 10 is equal to a EBIT of 7 because a small business valuation takes then net profit before tax and the P/E takes net profit after tax into consideration.