Business Valuation Methods
There are a number of different methods used to value businesses in today's marketplace, depending upon the size, profitability and nature of the business being valued.
Ultimately, valuations attempt to value the future maintainable profits of an enterprise. Generally the market accepts the latest year's profit as a basis for valuing small to medium-sized businesses, whereas for larger businesses, the average of the last two or three years profit together with a detailed and realistic operating budget may be preferred.
Asset Valuation Method
Under-performing businesses (where the profit derived from the business is not commensurate with the capital invested in the business by way of plant and stock) are valued according to the Asset Valuation Method.
There is no goodwill component and the value of the business is derived solely from the value of the plant and equipment (usually at current market value) and stock.
This method is used when other valuation methods give a value that is less than the net tangible assets of a business. This is based on the concept that a business owner is highly unlikely to sell his business for less than he can receive by way of an orderly disposal of the business assets.
Stock is valued at invoice cost, but may be discounted depending upon the amount of slow-moving or dead stock.
Plant & equipment is usually valued by an independent valuer.
Discounted Cash Flow Method
This method is favoured by the large accounting firms, although it is generally not applicable to small and medium businesses. In theory it is one of the best valuation methods. It attempts to put a value, in today's terms, on future cash flows in an enterprise.
A DCF valuation is based on the concept that the value of a business depends on the future net cash flow of the business discounted back to present value at an appropriate discount rate.
Future cash flows consist of two elements:
- The net cash amounts generated each year
- The net cash expected from the ultimate sale of the business at a point in the future
This method is useful where future cash flows can be predicted with reasonable accuracy, such as mining companies or large, stable companies.
It could also be applied where a small or medium company has long term contracts for the supply of goods and services or where the company has a history of regular cash flows.
Unfortunately, it is generally not suitable for valuing most other small to medium companies because of the difficulty of estimating cash flows some years into the future, the difficulty of estimating the sale price of the business in the future and the difficulty of assessing a suitable discount rate.
Return On Investment (R.O.I) Method
This is the most common method used to value businesses worth up to about $2 million. It should more correctly be called the Return to an Owner/Operator Method (R.O.O.) as it is based on a return to an owner before he draws a wage. It reflects the percentage returns to an owner on his capital investment in the business. The net profit used in the calculation is not the same as shown on the Profit & Loss Statement. A number of adjustments and “add-backs” are made to the P&L Statement to reflect the return to an owner and to add back non-business expenses and one-off expenses.
This is calculated as:
| Return on Investment (R.O.I)
R.O.I.’s for specific industries are based on sales evidence from previous business sales.
Given the R.O.I. for a specific industry (and making adjustment for special features of a particular business), the valuation is arrived at by transposing the above formula.
See the panel on the right for an example.
This figure is the total price of the business, including plant, stock and goodwill. The goodwill is derived by subtracting the value of plant and stock from the calculated purchase price.
For businesses in this price range the net profit or operating profit is defined as the return to an owner-operator before interest, tax, depreciation and owners’ salary. Hence a number of add-backs are made to the net profit as shown on the tax return.
For businesses in this price range, usually only the business assets are valued and sold. Assets include plant & equipment, stock, work-in-progress, trading names, goodwill and intellectual property.
Debtors are not included. These are retained by the vendor, who also pays out the creditors at settlement.
Price to Earning (P/E) Method and the EBIT Method
The EBIT Method
This is the most common method of valuing private businesses worth around $2 million and above. Relatively few add-backs are made to the book profit when valuing a large business. Interest is added back and depreciation in some cases. Owners’ wages are not added back (but may be adjusted to bring them in line with commercial rates) as these businesses are valued as running under management.
There are two related profit figures:
EBIT – earnings before interest and tax.
EBITDA – earnings before interest, tax, depreciation and amortisation.
The EBIT figure is usually used in valuation calculations, although the EBITDA can be used.
The EBIT method of valuation is simply calculated by the following formula:
Value of business
= Profit x EBIT Multiple
For example, if the EBIT is $2.5 million and the multiple is four, the value is $10 million. This is the value of the business assets comprising stock, plant & equipment and goodwill. Debtors and creditors are not usually included.
It is becoming increasingly common for the purchaser to buy the entire company by way of purchase of the shares in the company. In this case the final price is adjusted to reflect the other items on the balance sheet, including debtors, creditors, accruals for staff entitlements and perhaps company debt.
The EBIT multiple to be applied to value a business can vary from around two up to around six, and sometimes higher, depending upon a number of factors, including:
- • The total EBIT figure (a business earning an EBIT of $10 million will attract a higher multiple than one earning $1 million)
• The quality of the management team
• Stability of sales and profits
• The type of industry
• Barriers to entry
• The ability of the business to generate profits without the owner’s involvement
• Growth potential
• Market dominance.
Price to Earnings (P/E) Method.
This is the method used to value public companies. It can also be used to value private companies. The P/E method is essentially the same as the EBIT method except that the after-tax profit is used in the calculation and a different ratio is used to compensate for this.
The P/E ratio to be used in the calculations is extracted from sales evidence. It can also be extracted from published public company information. This method requires locating a few public companies similar to the one being valued. The average P/E of the public companies is derived. This figure is then discounted anywhere from fifty to eighty per cent to reflect the generally smaller size of the business and the lack of share liquidity compared to public companies.
Some private company owners get carried away when they see P/E’s of 12 to 15 for public companies similar to theirs. They need to bear in mind two factors:
- The discount factor mentioned above.
- The fact that a P/E is equivalent to about 1.3 times an EBIT because of the after-tax nature of P/E. That is, a P/E of 10 is approximately equivalent to an EBIT of 7.
This once-popular method simply values a business as multiple of its gross income, with each industry having its own multiple. It has fallen out of favour because the overheads required to earn the same income can vary significantly from one business to the next, even within the same industry. It is now used only to value accounting practices and real estate rent rolls. Virtually all other businesses are valued by using one of the methods above.