How to value a business: Methods to use
Whether you’re looking to sell your business or thinking of buying one, determining an accurate company valuation can be challenging.
So, how do you find out what a business is worth?
In this guide, we cover why you might need a business valuation, how to value a business based on profit, and various methods to help you accurately value a business.
Why would you need a business valuation?
There are several reasons you might need a business valuation, for example:
When you want to sell your business
When considering merging or acquiring another company
When searching for investors or business financing
When determining a partner’s ownership percentage
When adding new shareholders
When calculating specific taxes
As part of divorce proceedings
The best method for valuing a business will depend on its circumstances. For example, if you’re selling a small private business, you’ll probably sell its assets. But if you’re selling a mid-sized company, you’ll likely sell equity. So each of these scenarios requires a different business valuation method.
What impacts a business valuation?
A business is only worth what someone is willing to pay for it.
That said, several factors can impact a business valuation, including:
Length of operation
Assets and liabilities
Level of concentration
Staff and management
Intellectual property
Reputation and goodwill
Supplier and customer relationships
Cost of capital
Future growth potential
Let’s take a look at each one in turn:
Length of operation
Generally, the longer a business operates, the better its reputation, track record, cashflow, and loyal customer base to generate stable, recurring revenues. As a result, it’s likely to have a higher valuation than a business that’s only been trading for a year or two and could decline quickly.
Assets and liabilities
Businesses may have a combination of tangible and intangible assets that affect their valuation. For example, a business may have tangible assets with a resale value, like property, machinery, or physical stock. This makes it easier to value.
On the other hand, a business may have intangible assets, like intellectual property (such as patents or protected designs), customer goodwill, or a reputable brand that are harder to value.
For a straightforward asset valuation, you could sum up the tangible assets and subtract the liabilities - the amounts the company owes its creditors.
Level of concentration
The concept of concentration can also impact a business valuation. If your business is successful but only has a couple of key clients, this would negatively impact the value of your business since the loss of one client could potentially be devastating. In contrast, an extensive client base would positively impact the company's value.
The same applies to product and market concentration. If your products only appeal to a narrow market or you only sell one product, then your business would not be valued as much as a company that successfully sells a range of products or appeals to a broad market.
Staff and management
A skilled staff and an efficient, reliable management team can substantially impact the value of a company. On the other hand, a small company driven by a founder CEO is more risky because of its over-reliance on one key person.
Profits and losses
Companies generating significant gross margins (e.g. exceeding 35% for manufacturers and 25% for value-added distributors) typically get a higher business valuation.
Strong gross margins usually indicate that a company has a competitive advantage through differentiated products, unique distribution channels, and/or enhanced production capabilities.
A high gross margin typically translates into a higher EBITDA multiple because every additional dollar of revenue generates more profit than average.
Intellectual property
If the business has any intellectual property, such as trademarks or patents, it can positively affect the company’s value.
Reputation and goodwill
A company’s reputation and goodwill also affect a business valuation. Although it’s difficult to place a numeric value on an intangible asset, it’s still an essential factor.
An overwhelmingly positive reputation can significantly increase the business valuation, while a negative reputation can harm the chances of selling a business.
Supplier and customer relationships
Another intangible factor is the strength of the supplier and customer relationships. If these are strong, then the business valuation will be higher.
Cost of capital access
Investors borrow less when interest rates are high, which has a knock-on effect on any business valuation. Since the perceived risk is higher than when capital is cheaper and more accessible, there are fewer potential buyers and they will try to get a better deal.
Future growth potential
While past performance can demonstrate the financial stability of a business, its growth potential is also key. Buyers will want to know how well a business attracts and retains customers so that cashflow and revenue remain healthy. If a company loses customers as fast as it attracts them, there’s little growth potential.
Business valuation methods
Here are the 7 most commonly used business valuation methods:
Asset valuation method
The asset valuation method tells you what a business is worth after accounting for its assets and liabilities.
How it works:
Add together the assets such as cash, stock, equipment, plant, and receivables.
Then deduct liabilities, like bank debts and payments due.
The remaining figure is the net asset value.
For example, if a manufacturing business has $500,000 in assets and $200,000 of liabilities, the net asset value is $300,000.
Price-earnings ratio method
The price-earnings ratio (P/E ratio) is a business’s share price divided by its post-tax profits. For example, if your company has a price-per-share of $50, and your post-tax earnings per share is $10, you would have a P/E ratio of 5:
P/E ratio = $50/$10 = 5
To calculate your business value, multiply your most recent post-tax earnings by your P/E ratio:
Value = (Earnings after tax) x (P/E ratio)
Entry cost valuation method
The entry cost valuation method reflects what it would cost you to start a similar venture instead of buying an existing business.
How it works:
To determine an entry cost valuation, calculate the cost of:
Buying or financing assets
Developing products and services
Recruiting and training staff
Establishing a customer base
For example, you might calculate the following:
$300,000 to fund the initial equipment
$30,000 a month for overheads
One year’s trading to establish a customer base
Now you can make a comparative assessment.
For example, a business that meets the above criteria is worth at least $660,000 ($300,000 for equipment and $360,000 in overheads for 12 months). Now you can figure out what savings you could find to bring costs down and whether it’s more viable for you to start a business or buy an existing one.
ROI-based valuation method
The ROI-based business valuation method uses the company’s actual profit value plus the estimated return on investment (ROI).
How it works:
If you’re asking investors for $250,000 in exchange for 25% of your business, then you’re using the ROI-based method to determine the value of your business.
So, if you divide the amount by the percentage offered — $250,000 divided by 0.25 — you get a business valuation of $1 million.
Capitalised future earnings method
The capitalised future earnings method is most common when valuing small businesses. It lets you compare different companies to see which would give you the best return on investment (ROI).
When you buy a business, you purchase its current assets and potential future profits, known as future earnings. The future earnings are “capitalised” – or given an expected value – based on the expected ROI, shown as a percentage or ratio, where a higher ROI is best for the buyer.
How it works:
First, calculate the company’s average net profit for the past three years. Consider any conditions that might make this figure challenging to repeat.
Next, determine the expected ROI by dividing the company’s expected profit by its cost and turning it into a percentage.
Then, divide the company’s average net profit by the expected ROI and multiply it by 100 to value the business.
For example, suppose you’re considering buying a bakery with an average net profit of $100,000 after adjustments. You want an ROI of 20%. So you divide $100,000 by 20% and multiply it by 100 to get a business value of $500,000.
Earnings multiple method
The earnings multiple method helps you compare different businesses, where you multiply the earnings before interest and tax (EBIT) to give a value. The “multiple” could be industry-specific or based on business size.
How it works:
First, calculate the earnings before interest and tax (EBIT) of the business.
Next, consult a business valuation expert for an accurate business earnings multiple.
Then, multiply your EBIT by your earnings multiple to find the business value.
For example, suppose you want to buy a sports store with an EBIT of $100,000 and an industry-specific multiple of 2. The business value would be $200,000.
Comparable sales method
The comparable sales method simply compares what similar businesses have sold for.
How it works:
You can check out the recent sales of businesses in your industry and location from:
Business sales listings in industry magazines, journals or websites.
Business brokers, who can also advise on the value of the business.
For example, say you wanted to buy a coffee shop. After checking recent sales in your location, you know that $150,000 is a realistic value for this kind of business.
Keep your business running smoothly with MYOB
Valuing a business is challenging. But with the correct methods, you can determine a fair price for both parties.
MYOB’s accounting software can help companies stay on top of their finances. With all financial information to hand, it makes the process of valuing a company much easier.
Disclaimer: Information provided in this article is of a general nature and does not consider your personal situation. It does not constitute legal, financial, or other professional advice and should not be relied upon as a statement of law, policy or advice. You should consider whether this information is appropriate to your needs and, if necessary, seek independent advice. This information is only accurate at the time of publication. Although every effort has been made to verify the accuracy of the information contained on this webpage, MYOB disclaims, to the extent permitted by law, all liability for the information contained on this webpage or any loss or damage suffered by any person directly or indirectly through relying on this information.