“The intrinsic value of a business is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows.”
Aswath Damodaran
Understanding how to value a business for purchase must first start with the reason.
The reasons why buying a business is chosen over starting from nothing, known as a greenfields business, is for the following reasons:
Setting up a business from nothing can take many years to reach profitability while it develops market share or a client base, contacts and relationships, brand recognition and systems proven to work. Buying a business cuts that time down to an immediate return on your investment and ideally room to improve with your involvement.
Growth can be better achieved in an existing business by acquiring another business that is in the same or complementary field, allowing the purchaser to be more efficient and or provide greater access to markets to expand its revenue.
Buying a business can result in less risk of failure as you are buying something that has proven success.
Understanding The Business Valuation
The key to buying a business is understanding its true value to the market as a stand alone investment and then to you the purchaser.
These two can be very different values. If the value to you is greater than the market this means you can afford to bid higher than the market if it is a competitive sale process.
Examples of where the value to you is greater than the market is if it can provide an existing business with more cost efficiencies and/ or access to new markets that will improve your consolidated businesses profitability.
You want to ensure you’re making a smart investment, not overpaying for hidden liabilities. Business valuation is a critical step in this process, and getting it right can set the foundation for future success.
Remember to remove all emotion when deciding on the value of a business. Emotion has little to play in determining the value of a business.
That is not to say that emotions will have no effects on your decision. Emotions will have an effect and arguably they have value, however this component must be separated from the value of the business.
A common emotional trap in buying a business is you can end up buying yourself a job, which is OK if that is what you want to do and cannot get that job any other more efficient way.
In this guide, we’ll break down how to value a business for purchase, using clear explanations and relatable examples to make the process straightforward.
1. What is Business Valuation?
Business valuation is the process of determining the economic value of a business.
It considers factors like the company’s assets, liabilities, earnings, and market position.
For example, if you’re buying a café, you’re not just paying for the tables and coffee machines (tangible assets) but also for its brand, customer base, and reputation (intangible assets).
2. Why Business Value Matters
Determining the correct business value ensures you’re paying a fair price while avoiding costly surprises later.
It also gives you a clear picture of the business’s potential for future profits and return on investment (ROI).
Example: Imagine considering two similar businesses for purchase. Same Revenue however one has a net profit of $200,000 annually, and the other has $120,000. The higher profitable business appears the better of the two however without understanding how these profits were calculated or whether they’ll continue, you could easily overpay or find that it requires more work or resources than first thought It turns out the more profitable business does not include wages of $120,000 of the owner who is actively involved in the business and if they are not there it will require another staff of equal pay. The lower profitable business includes all costs and is now a better purchase, all other financial metrics being equal.
3. Business Valuation Methods
There’s no one-size-fits-all formula for valuing a business. The method you choose depends on the business’s size, industry, and unique characteristics. Here are the most common methods:
Market-Based Valuation
This method compares the business to similar businesses recently sold in the market.
Example: A coffee shop in your area sold for 2x its annual net profit. If the business you’re looking at earns $150,000 annually, its market value might be $300,000.
Asset-Based Valuation
This method calculates the value of the business based on its assets minus liabilities.
Tangible Assets: Equipment, inventory, business premises.
Intangible Assets: Brand reputation, intellectual property, customer relationships.
Tangible Liabilities : Creditors, Tax Debt, Mortgage on Assets, Employee Leave Entitlements
Intangible Liabilities : Contingencies, Law suits, Customer Claims, Environmental matters, Ageing Plant and Equipment needing to be replaced
Capitalised Future Maintainable Earnings Method
The capitalised future maintainable earnings method is the most common method used to value small businesses. The profit excluding Interest,Tax, Depreciation and Amortisation is then adjusted to take out any abnormal expenses and add in any expenses needed once the Vendor (seller) is removed. This is a complex process and involves a large amount of Due Diligence work to ensure that the result is an earnings amount you the buyer can expect to maintain moving forward.This method depends heavily on factors like market conditions, business history, and growth potential.
Once this earnings amount is determined we apply an earnings multiple to determine the value. The multiple is a reflection of the risk and many factors that represent the reliability of the earnings. If it is a reliable dependable profit with low risk it may have a multiple of 5. If it is very risky and could result in reduced or dropped earnings in the short term it may have a multiple of 1.5 – 2.
Example: If a business is expected to generate $100,000 annually for more than five years the Multiple of 5 would value the business at $500,000. If it was a riskier business and we could not see past 3 years we may apply a multiple of 2 valuing the business at $200,000. .
4. What is a Profit Multiplier
A simple way to understand a profit multiplier is to understand Risk. The riskier something is the lower the Multiple. The safer and more reliable the business earnings are the lower the Multiple.
One way of understanding a Multiplier is to consider a Multiple in the same way as how you see interest rates. Interest rates for money you invest in a Bank is safe and reliable and the rate on a term deposit may be 5% per Annum. If you were going to invest in a small start up business without a proven sales track record you would not be happy with a 5% return you would want a much higher return say 50% per annum. Lets now compare these two percentages in terms of multiples.
Assuming the return is consistent and the interest rates do not change, in simple terms a 5% never ending return would be a 20 times multiple and the 50% return would be a 2 times multiple.
Example: If the business generates $200,000 in annual net profit and the industry average multiplier is 3x, the business could be worth $600,000. As a return this is a 33% return on the amount paid for the business. Makes sense as business is always risky. If you had $600,000 invested in a Bank Deposit earning 5% it would earn $30,000 per year but it is low risk and your principle is guaranteed to be returned. The value you paid for the business is assumed to be the same or greater when you choose to exit, however this is a greater risk than a bank deposit.
5. Key Factors in Determining Business Value
Future Profits
The most important consideration is whether the business will continue to generate profits. Factors like market trends, competition, and customer loyalty play a role.
Financial Statements
Review the profit and loss statements, balance sheet, and cash flow to ensure the numbers are accurate and reflect the business’s current market position.
Business Assets
Consider both tangible (equipment, property) and intangible assets (brand reputation, intellectual property).
Market Conditions
What is the current market value of similar businesses? A booming industry might justify a higher valuation, while a struggling market could mean a lower price.
Liabilities
Ensure there are no hidden debts or obligations, such as unpaid taxes or outstanding contracts.
6. The Importance of Professional Advice
Valuing a business isn’t just about plugging numbers into a formula.
It requires a deep understanding of financial records, industry trends, and market conditions. This is where professional accountants like Bishop Collins can help.
Why Choose Bishop Collins?
Perform detailed financial analysis and cash flow projections.
Experts in identifying risks and hidden liabilities.
Provide accurate, objective advice tailored to your investment goals.
7. Final Tips on How to Calculate the Value of a Business for Sale
Always review financial records carefully.
Get the business independently valued by a Chartered Accountant.
Consider the business’s growth potential, not just its current performance.
Don’t overlook intangible assets like brand value and customer loyalty.
Example: Buying a restaurant with strong online reviews and loyal customers might justify a higher price than one without an established reputation.
Secure Your Investment with Bishop Collins
Determining how much a company is worth is a complex process, but you don’t have to navigate it alone.
At Bishop Collins, we specialise in business valuation for buyers, ensuring you pay the right price and maximise your investment.
Contact us today to make a confident and informed decision for your next business purchase.
