Valuing a Business

Valuing a Business
by BizHelp24
October 19, 2005

Chapter 6: Valuing a Business

Arguably, a business is worth what-ever someone is willing to pay and therefore will vary from person to person.

Today, there are over twenty different ways of valuing a business and this is why many people cumulate different prices. The price that the seller asks for is almost never what they will receive and is usually reduced in value through negotiations between themselves and you- the buyer.

It is important that you value the business yourself (with the help of assistance) so that you can be sure that you are not over paying for a business.


By paying too much, you will encounter further financial problems if the business doesn't turn out to be successful. On the other hand, those businesses that do prove successful will serve justice to the amount you paid.

In most cases, a business should be valued against the ability it has of generating a good cash-flow. In other words, the price will be dependent on the level of consistency the business has at making profits. All businesses are unique and therefore it is important that you use the most appropriate valuation method to determine a realistic value.

6a) Be Aware!

There are many people out there who use the wrong valuation methods to price a business and consequently pay too much. To give you an idea, look at a couple of them - the first of these is the Comparison Approach:

Say a small business has a Net Profit figure of £5,000 a month and was sold for £200,000 and the business that you want to buy also has the same Profit figure. You would be wrong to think that because they have the same Profits, they should both have the same value. The business that was sold for £200,000 may have only been operating for a few months and therefore, chance is that the profits are likely to increase. The business you have interest in may have been running for a number of years and profits may have stabilized. Also, that business may have a shorter operating period, say, five days a week, compared to your potential business' operating period of six days a week. The moral is that you should never compare prices to businesses with similar profits.

Quite often, many people have confidence that the seller has provided a realistic value and therefore they try to make a bargain by reducing this price by say, 10%. The trap that you may have fallen into here is that the seller may have inflated the price anyway in an attempt to make a bit more money out of the deal. So in theory, you haven't made anything from using this approach and consequently will have paid the price that the business is worth or maybe even more.

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Valuing a Business: The Asset Value and Payback Value

6b) The Right Approach

Different methods are also used depending on the size of the business and so we have stuck to the main ones that are generally used to valuing Small Medium Enterprises - 'SME'. During this time, you should consult your accountant to determine the best approach and also allow them to make the necessary calculations: despite the simplicity they may show, the figures involved may take time to reach through previous calculations taken from the accounts. Further, most of the figures and values you need should have been obtained during your due-diligence period.



6c) Asset Value

Using assets to value a business is more commonly used when it is considered as asset-intensive i.e. the assets heavily contribute to the level of profit that is generated. The Net asset value can therefore be obtained from the sum of the following:

•An accumulated value of all the fixed assets including plant, land and machinery.

•The value of any leasehold improvements: this includes any refurbishments or modifications the owner may have made such as new office space and/or equipment. You should note that the leaser can make the owner return the leasehold to the original state should these changes not be beneficial to you. Any improvements would therefore not be included in the overall value.

•The value of the inventory which can include raw materials, stock and anything that may be considered as work-in-progress.

•The value of intangible assets which not only includes goodwill but also logos, trademarks, and any patents.

6d) Payback Value

This is where you will set a price determined by the period that you expect to get a return for your initial investment. For example, a newsagent has a Net Profit of £30,000 and you expect to start making money after the third year. In which case, you would multiply this period by the Net profit i.e. £30,000 x 3 years = £90,000. This method strongly validates the fact: a business is only worth what someone is willing to pay.

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Valuing a Business: Return on Investment, Income Value & Owner Benefit Value


6e) Return on Investment/Capital

For a return on investment value, we are assuming that no fixed price has been given for the business and therefore you will use the net profit and your proposed return on investment percentage to determine a price. For example, a business makes a net profit of £20,000 and you expect an investment return of 10%. In which case, £20,000 divided by 10% gives a value of £200,000.

A return on capital approach would assume that a fixed price has been given for the business in which you can use to determine whether it is a wise investment. It may be that your money is worth investing elsewhere such as a bank that offers an average return of around 5%. Using basic terms, let's say the business is for sale at £100,000 and the net profit is £10,000. To find the return rate, you would divide the net profit by the business price and then work it out as a percentage: (see below)

£10,000 divide by £100,000 = 0.1

0.1 x 100% = 10% Return on Capital Employed

With a 10% Return on Capital Employed, It would therefore be a good investment as the rate is higher than that of the bank.

Should the rate be unacceptable, you would use the return on investment method to determine a more suitable price in order to give you your desired return.

6f) Capitalization of Income Value

This method is used more commonly for services and therefore considers the intangible value of the business. Such businesses are usually contract orientated and consequently you can fall into high risk situations. It would further be wise to use an accountant to determine that the business would have a favourable outcome should it suffer from a change of ownership.

This method involves using factors to determine an average figure called the "capitalization rate", say, between 1 (low) and 5 (high) to multiply against the owner's discretionary income (profits, owner's salary, non essential expenses etc) the following list has a low score potential of 11, and a high of 55. Such factors will include:

•Profitability (concentrate on future, not past, profitability)

•Competition (present and future)

•Customer base, particularly those under contract

•Full risk analysis

•Your suitability (your standard of experience and knowledge in the industry)

•Future potential for the industry

•Why the present owner is selling

•How long the business has traded

•How many past owners

•Location of business to customers

•Where growth lies within the business

If after rating the above as, say, 20 and the discretionary income is £20,000, the sum would be:

20 x 20,000 = £200,000 purchase price

As these factors are very subjective, it could be difficult to agree an exact "capitalization rate" and therefore an alternative valuation method should be adopted if you are too far from the sellers rate.


6g) Owner Benefit Valuation

This method uses a figure between 2 and 3 (depending on what you think is appropriate) and multiplied by the owner's discretionary cash-flow. Discretionary annual cash-flow can be referred to as the money that is not used in the operations of the business - profits, owner's salary, non essential expenses etc. Using this approach gives a value that reflects the business' ability to generating cash-flow and profits. If you want, say, 2.5 times the owners total benefits and the discretionary income is £20,000, the sum would be:

2.5 x 20,000 = £50,000 purchase price

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Valuing a Business: The Multiplier Valuation




6h) Multiplier Valuation

This area is very subjective and there will be a variation in people's attitudes and opinions for the figures involved. The figures that we have given are USA based and should be used for guidance purposes only to give you an idea of the differences between industries. The value of the business is derived from the multiplication of a figure (or percentage) and a financial value of the business.

Below are multiplication figures that have been supplied by the Business Brokerage Press, located in the USA, from their publication 'The 2001 Business Reference Guide'.

Type of Business "Rule of Thumb" valuation

Accounting Firms 100% - 125% of annual revenues

Auto Dealers 2-3 years net income + tangible assets

Book Stores 15% of annual sales + inventory

Coffee Shops 40% - 45% of annual sales + inventory

Courier Services 70% of annual sales

Day Care Centres 2-3 times annual cash flow

Dental Practices 60% - 70% of annual revenues

Dry Cleaners 70% - 100% of annual sales

Employment & Personnel Agencies 50% - 100% of annual revenues

Engineering practices 40% of annual revenues

Florists 34% of annual sales + inventory

Food/Gourmet Shops 20% of annual sales + inventory

Furniture & Appliance Stores 15% - 25% of annual sales + inventory

Gas Stations 15% - 25% of annual sales + equip/inventory

Gift & Card Shops 32% - 40% of annual sales + inventory

Grocery Stores 11% - 18% of annual sales + inventory

Insurance Agencies 100% - 125% of annual commissions

Janitorial & Landscape Contractors 40% - 50% of annual sales

Law Practices 40% - 100% of annual fees

Liquor Stores 5% of annual sales + inventory

Property Management Companies 50% - 100% of annual revenues

Restaurants (non-franchised) 30% - 45% of annual sales

Sporting Goods stores 30% of annual sales + inventory

Taverns 55% of annual sales

Travel Agencies 40% - 60% of annual commissions

Veterinary Practices 60% - 125% of annual revenues


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