Business Valuation Methods

Get it wrong and it will cost you dearly, but get it right...

Ah yes, mysterious mystic crafts, or as I like to call them: business valuation methods...I can hear the ruffle of big stacks of notes being fingered by rich bankers. I can smell expensive suits and see the glint of swiss watches, while lawyers flourish pen's along contracts...

That's the kind of mystique and prestige that the big city and the media would have us all aspire to, because the banks who provide the funding capital for these sorts of deals stand to make millions in terms of set up fees, and interest charges, and the lawyers make money setting up the contracts, and the big corporate accountants make money performing due diligence and so it goes on.

Meanwhile back in the real world, most business transactions that happen are not glamorous multi-million corporate deals, but honest folk investing their life's savings to take significant risks, buy a business and hopefully receive rewards over and above a salary.

As trade and commerce have been around for a very long time, it's comforting to know that the principles of business valuation are well established.

On the page Small Business Valuation we discussed the principles of going concern, asset based valuation approaches, and the concept of goodwill. Now to combine these ideas together:

Earnings Related Business Valuation Methods

It won't be long after you've started discussing business valuation methods, that some bright spark will note that the numbers are all prepared on a historic basis, and don't bear any relation to what may or may not happen in the future.

And that valuing the assets alone doesn't give any consideration to the future potential, and earnings of the business. That's when considering valuations linked to earnings is necessary.

The premise is that the true value of a business is linked to it's ability to generate future earnings from the assets it has now.

Earnings based approaches take the possible business price and divide it by the earnings to work out the price earnings ratio.

While the price earnings ratio is often used for stocks quoted on a publicly traded exchange, for a private business investment, you need to take into account some other factors:

• Every investment has a risk element to it. The higher the risk, the higher the expected return.

• That invested capital must generate at least a satisfactory real return for the owner, and that means substantially above inflation.

• Alternative investments availabe, and the returns they would generate.

The outcome at the end of these computations is known as a capitalization rate - a rate which can be used to determine the price of the business, based upon the required rate of return.

For example, a business owner requiring 25% return on capital on a business making adjusted earnings of $100,000 would want to pay no more than:

$100,000 / 25% = $400,000

to ensure that they achieve the required return on capital they are seeking.

Time Value of Money

The time value of money is a very important concept in finance. A dollar in your hand today is worth more than a dollar in your hand tomorrow, because you can use that dollar (even if you just put it in a bank savings account), and earn a return on it.

This leads us to the conclusion that any consideration of future earnings must be worth less in today's terms, and maybe therefore one thing a business valuation method should do is adjust future earnings downwards in some way.

This type of valuation is known as a discounted cash flow valuation. This simple discounted cash flow calculator will help you get to grips with the principles.

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