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Evaluating the business for your targeted ROI(Return on Investment)

Evaluating the business

Although there are several formulas you can use, there are no black-and-white answers on valuation techniques. It’s important to conduct your own research, then get independent advice from a business valuer or broker. Here are four of the most commonly used valuation methods.

Method 1: Asset valuation

The value of a business is determined by adding up the value of its assets and subtracting liabilities. It tells you what the business would be worth if it were closed down today and its assets sold off, but it doesn’t take into account the ability of those assets to generate revenue in the future. For that reason, it may understate the true value of the business.

How it works

  1. Add up the value of all the assets such as cash, stock, plant and equipment and receivables.
  2. Add up liabilities, such as any bank debts and payments due.
  3. Subtract the business’ liabilities from its assets to get the net asset value.

Example

Richard wants to buy a manufacturing business. Here’s an extract from the business’ balance sheet.

If the business has assets of $300,000 and liabilities of $200,000, the net asset value of the business is $100,000.

What about goodwill?

This method doesn’t include a value for goodwill, so may understate the true value of a business. Goodwill is the difference between the true value of a business and the value of its net assets. It can be crucial to the value of retail and service-based businesses.

For example, if you value a business such as a hairdressing salon, where service, location and reputation are important, the value of any goodwill would have to be added to net assets to get a valuation.

Can goodwill be transferred if you buy a business? It can come from physical features such as location, or from personal factors, like the owner’s reputation or their relationships with customers or suppliers, which may not be transferable.

If the business is underperforming and has no goodwill, then using the net assets valuation method could be an accurate way to value it.

Method 2: Capitalised future earnings

When you buy a business, you’re not only buying its assets but also the right to all profits that business might generate.

Capitalising future earnings is the most common method used to value small businesses. The method looks at the rate of return on investment (ROI) that you can expect to get from the business.

How it works

  1. Work out the average net profit of the business over the last three years using its profit-and-loss statements, adjusting profit for one-off expenses or other irregular items each year.
  2. Decide the annual rate of return you’re looking for (e.g. 20%). There are no rules about the number you choose, except higher risk should give higher returns. Compare the business with other investment opportunities. You can also look at the rate of return that similar businesses in your industry achieve.
  3. Divide net profits by the rate of return to determine the value of the business, then multiply by 100.

Example

David is looking at buying a bakery business with average net profits of $100,000 per annum after adjustments. David wants an annual rate of return of 20%. The capitalised earnings valuation is:

Method 3: Earnings multiple

Multiply the business’ earnings before interest and tax (EBIT) by your selected multiple. For example, you might value the business at twice its annual earnings — so a business with an EBIT of $200,000 might be valued at $400,000.

The multiple you choose will depend on the industry and the growth potential of the business. A service-based business might be valued at as little as one year’s earnings, while an established business with sustainable profits might sell for as much as six times earnings.

Method 4: Comparable sales

Whatever other valuation method you use, you should also look at prices for recent sales of similar businesses. It makes sense to know what is happening in the market you’re interested in.

Speak to business brokers and gauge their feeling about the business’ value. They might know what similar operations are selling for and how the market is placed. Check business-for-sale listings in industry magazines, newspapers or websites.