There are many ways to approach valuing a business, and finding the right valuation methods depends on the size, profitability and nature of the business. Ultimate, a business valuation attempts to value the future maintainable profitability of an enterprise. The right company to value a business should provide an accurate and credible business valuation with a defensible business valuation report.
The valuation process is intricate, but has grounding principles to determine the difference between a valuation with a firm foundation, and those without. American Fortune business valuation’s broad and unique expertise and experience results in extraordinarily accurate and defensible business valuation reports. These reports can serve multiple purposes including wealth preservation, increasing wealth, sale of a business, business acquisitions, divorce, business loans, estate planning, buy-out agreements or business exit and succession planning. As the firm also performs Mergers & Acquisitions services, and business exit planning they possess expertise and experience which most valuation firms do not.
American Fortune Business Valuation’s additional expertise and experience allows them to create very accurate, defensible, and low-cost business valuation reports.
Asset Valuation Method in Valuing a Business
The asset valuation method is best for underperforming businesses. Underperforming businesses experience profits that are not commensurate with the capital invested in the business by the way of plant and stock. There is no goodwill component and the value of the business relies solely on the value of the plant and equipment, typically at current market value, and stock.
Experts turn to this method when other small business valuation methods give a value which is less than the net tangible assets of a business. The concept of the asset valuation method is that business owners are not likely to sell a business for less than they can receive through an orderly disposal of the business assets. Stock is valued at invoice cost but could be discounted depending on the volume of slow-moving or dead stock. The plant and equipment usually receive their assigned value from a valuation specialist.
Discounted Cash Flow Method in Valuing a Business
Large accounting firms favor the discounted cash flow method, or DCF, although it’s generally not applicable to small or medium-sized businesses. In theory, this is one of the best valuation methods. It works to place a value, in present-day terms, on future cash flow of an enterprise. A DCF valuation relies on the concept that the value of the business depends on the future net cash flow discounted back to present value using an appropriate discount rate.
The Two Elements of Future Cash Flows
There are two driving elements with determining future cash flow.
- The net cash amounts a business generates each year.
- The net cash expected from the ultimate sale of the business at a point in the future.
The DCF method is useful when experts can predict future cash flows with reasonable accuracy, such as with large, stable companies. This method could also serve small or medium companies when they possess long-term contracts for the supply of goods and services, or where the company has a history of regular cash flows.
Unfortunately, it is not suitable for small business valuation or medium companies for multiple reasons. The primary challenges in these cases include estimating cash flows years into the future, assessing future sales prices of the business, and difficulty in determining a suitable discount rate.
Valuing a Business with the Return on Investment (R.O.I.) Valuation Method
The R.O.I is one of the most common small business valuation methods used to value businesses worth up to approximately $2 million. Although recognized as the R.O.I. method, it should be called the Return to an Owner/Operator Method or R.O.O. as this method evaluates the return to the owner before they take a wage.
This method reflects the percentage returned to an owner on their capital investment in the business. The net profit used in this calculation is not the same as the calculation used when creating a Profit and Loss Statement.
Adjustments and “add-backs” are made to the P&L statement to reflect the return to the owner and to add back non-business expenses. The calculator for this process is:
Return on Investment (R.O.I,) = Net Profit / (divided by) Purchase Price x 100 / (divided by) 1
R.O.I.s for specific industries use sales evidence from the previous business sale. Given the R.O.I. for a specific industry and making adjustments for special features of any business, the valuation transposes the above formula as:
Purchase Price = Net Profit / (divided by) R.O.I. x 100 / (divided by) 1
This figure shows the total price of the which includes the plant, stock, and goodwill. The goodwill is determined by subtracting the value of the plant and stock from the total purchase price. For businesses in this price range (worth up to about $2 million), the net profit is the return to an owner/operator before interest, tax, depreciation, and owner’s salary.
The add-backs are made to the net profit, as shown on the tax return. Businesses in this price range usually only have the assets valued and sold. Assets include the plant, equipment, stock, work-in-progress, trading names, goodwill, and intellectual property. Debtors are not included, as these are retained by the vendor who pays out the creditors at settlement.
The EBIT Method for Valuing a Business
The EBIT method is the most common for valuing a business worth approximately $2 million and above. This method uses two related profit figures. First, is EBIT – Earnings Before Interest and Tax. Second, is EBITDA or Earnings Before Interest, Tax, Depreciation, and Amortization. The EBIT figure serves greater purpose during valuation calculations however EBITDA is an alternative option for these calculations.
Relatively few add-backs apply to the book profit when valuing a large business. Interest is added back, and sometimes, depreciation is as well. However, owner’s wages are not added, but could call for an adjustment to bring them into line with commercial rates as these businesses are valued as running under management.
The EBIT method of valuation uses the following formula:
Value of the Business = Profit x EBIT Multiple
For example, if the EBIT is $2.5 million, and the multiple is four, the value is $10 million. That is the value of the business’ assets including stock, plant and equipment, along with goodwill. Debtors and creditors rarely fit into this calculator or valuation. It is becoming increasingly common for a purchaser to buy the entire company through the purchase of shares. Here, the final price would undergo adjustments to reflect the other items on the balance sheet including debtors, creditors, accruals for staff entitlement, and in some cases, company debt.
The EBIT multiple can range between two and six, and sometimes it can go higher depending on several factors. Those factors can include:
- The total EBIT figure (A business earning an EBIT of $10 million would attract a higher multiple than a business earning $1 million)
- Quality of the management team
- Stability of sales and profits
- The industry
- Barriers to entry
- The business’ ability to generate profits without the owner’s involvement
- Growth potential
- Market dominance
Price to Earnings (P/E) Valuation Method for Valuing a Business
Many public companies use the P/E valuation method, in fact, it’s the most common way for valuing a public business. However, private companies can use this valuation method too. The P/E method, at its core, uses the same approach as the EBIT method. The difference is that the after-tax profit is present in the calculation, and the calculation uses a different ratio to compensate for using the after-tax profit.
The P/E ratio used in the calculations comes from the sales evidence. It can also come from published public company information. This method requires locating a few public companies similar to the one being valued, and it often uses the average P/E of those public companies. For private companies, this figure can undergo a 50 to 80% discount to reflect the 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/Es of 12 to 15 for the public companies similar to theirs. They need to consider two key factors:
- The discount factor mentioned above.
- That the P/E is equivalent to approximately 1.3 times an EBIT because the P/E is after tax. This means that a P/E of 10 is about the same as an EBIT of 7.
Rule-of-Thumb Valuation Method
The once popular ‘rule of thumb’ method for valuing a business considers multiples of its gross income, with each industry having its own multiple. This business valuation method has fallen out of favor because the overhead required to earn the same income can vary drastically from one company to another, even when they are in the same industry.
Now, the rule-of-thumb valuation method only serves for accounting practices and real estate rent rolls.
Business Valuations are governed by Valuation Standards Business Valuation Associations. The top two organizations are The Uniform Standards of Professional Appraisal Practice and The National Association of Certified Valuation Analysts.
Learn more about valuing a business, and the different methods of business valuation by contacting American Fortune Business Valuations at (800) 248-0615. Speak with one of our business valuation experts to explore the different methodologies behind business valuations and when business owners might need a valuation.
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To learn more about Valuation of a Business and methods or a valuation of a business contact us at (800) 248-0615 and speak with one of our Business Valuation experts.