There are many different methods used to value a business, most of which conclude similar results, however it is ultimately subjective and based on what the sellers view of the value of the business is, and what the buyer is willing to pay. There are many factors which have to be taken into consideration such as:
- The financial position of the business (good or bad)?
- How long has business been in operation?
- How long has the present owner owned it?
- Are their audited financial records for the business?
- What condition are the assets in?
- Is there a renewal option on the lease?
- Are the products or services in demand?
- Are the products being marketed effectively?
One of the most effective ways of valuating a small to medium size business is to use the following formula, which over the years has proved itself in the business broking industry to be fairly accurate. The method is based on using the average of three valuations namely; Extra Earning Potential (E.E.P.), Return on Investment (R.O.I.) and the Payback Period.
- Extra Earnings Potential (E.E.P.) – The extra earning potential is the extra one expects over and above a salary, plus the investment income from banking the money available to buy a business when one takes on the risk of owning that business.
- Return on Investment – The return on investment is the rate of return one receives from investing the capital cost of the business taking into consideration the risks associated with that business.
- Payback period – The Payback Period uses an experienced “guess” as to the number of months one would expect to take to pay for the business out of the monthly profit. When making use of the above formula there are certain “cap rates” which apply and are most important when valuing a business.
As a professional business broker, it is our responsibility to advise clients on the valuation of their business. Based on the complexities and subjectivity, we also advise our clients to have their accountant or auditor assist with valuation inputs, as they have a better view of the businesses historical financial position.