Every business owner should have a good idea of what their business is currently worth even if they don’t intend on selling the business soon or at all. But you may also need to know what a business is worth in the following non-exhaustive list of circumstances. How many reasons do you have to find out what a business is worth?
- Buying a business or division externally or internally
- Selling a business or division externally or internally
- Shareholder/partner agreements and buy/sells
- Estate and superannuation planning
- Family law – separation and prenuptial
- Business insurance policy structuring
- Personal insurance policy structuring
- Actual death or disability of the owner/(s)
- Litigation as plaintiff or defendant
The problem is that business valuations are a complex mixture of science and art that are further confused by ‘listing prices’ displayed by business brokers and their often flawed ‘rule of thumb’ methods that make no commercial sense. The steps to value a business are fairly straightforward but need to be followed diligently.
The valuation method
The transfer price of any business (or any asset for that matter) will almost always come down to the agreed price between a knowledgeable and willing but not anxious seller and a knowledgeable and willing but not anxious buyer. The purpose of a valuation therefore is to indicate to the seller and/or the buyer what price would represent a favourable financial outcome to them based on their required rates of return. The purest method of valuation is the discounted cashflow (or net present value) approach however this method requires precise knowledge of all cash inflows and outflows between now and infinity for the business. Whilst this method is great for some financial assets with guaranteed cashflows it is impossible to apply to a business with variable cashflows.
The next best alternative used by most business valuers is a modification of the above method called the capitalisation of future maintainable earnings method. This method requires the valuer to forecast the most likely annual earnings figure (earnings before interest and tax) that will then be used as an annual recurring amount in the calculation. The valuer then applies a capitalisation rate to those earnings based on a required rate of return to give the business a value.
Future maintainable earnings (profits)
The earnings will usually be calculated based on the past performance of the business as well taking into account estimated projections. The net profit from the financial statements is adjusted to take into account various factors that are artificial or non-commercial amounts in the financial statements.
The adjusted earnings before interest and taxes (EBIT) for each historical and projected year are then weighted based on some assumptions to formulate a weighted average EBIT or future maintainable earnings, which is considered to be the likely annually recurring earnings amount going forward based on the methods and assumptions used.
The capitalisation rate is inversely proportional to the required rate of return on the investment in the business. The higher the required rate of return, the lower the capitalisation rate and hence the lower the business value. Conversely, if there was no risk investing in a business the required rate of return may be as low as 5% and the business would be valued at 20 times the future maintainable earnings. This is almost never the case though as there are many inherent risks associated with running businesses. It is more likely that the required rate of return would be between 15% and 100% with corresponding capitalisation rates between 7 and 1 times respectively. The more risk, the higher return an investor would need compared to the investment outlay to make the investment.
As the future maintainable earnings has already been calculated the only way to change the value of the business is to change the required rate of return. The higher the required rate of return, the less that the business is valued for the same level of future maintainable earnings.
In the free business valuation calculator that I created on my website there are only 7 factors that influence the required rate of return. Bear in mind this is an oversimplified example as in practice the factors could total over 100. The responses to these factors have a significant impact on the indicative value of the business and are all related to business risks.
Assumptions relied upon
Valuing a business is a complex science that requires an enormous amount of information gathering, due diligence and industry knowledge to give an accurate opinion of value. Due to the limited scope of any basic business valuation calculator the following assumptions or similar are usually made. These assumptions may or may not be accurate and will depend on the specifics of each business.
- The information provided by the business is materially correct;
- The past is a good indicator of future performance of the business;
- The economic, industry and geographic factors are stable;
- Key customers, suppliers and employees are supportive of the transaction;
- All related party transactions are at fair value except for those specifically identified in the adjustments;
- All inventory, plant, equipment, fittings and fixtures necessary for the operation of the business are included;
- All depreciation amounts are book entries only and no significant upgrades of assets are required in the near future; and
- All necessary intangibles and regulatory permits are transferable.
How to calculate goodwill
Goodwill is simply the difference between the value of the business and the values of the identifiable net tangible assets (excluding bank loans and other loans). Should the indicative value be greater than the net tangible assets you have that much goodwill but alternatively, should the indicative value be less than the net tangible assets of the business, then the business would have negative goodwill and the assets would hold the only salable value.
Get a complete 7-page valuation report in less than 15 minutes from the Free Business Valuation Calculator. A short instructional video on business valuations is included.