Whether you are selling your business or you are buying a business, you should know the value of the business that you are going to sell or buy. Business valuation is not difficult if you choice the right method and apply the appropriate principles. There are three different approaches in business valuation.
They are:
- Assets or cost approach
- Income approach
- Market approach
Depending upon what type of business you are going to buy or sell. You have to select the suitable one.
1. Assets or cost approach method
This method is suitable for those business organisations where assets are more valuable than the business as a result of the income generated. For example, to determine the value of a charity fund organisation, the asset approach is most suitable, as it does not generate income. A total asset minus total liabilities determines the value of the business in this method.
This method ignores the goodwill of the business.
That is,
Business value= total assets- total liabilities
2. Income approach method
This method is chosen when the business, by virtue of the income generated, is worth more than its assets. Most businesses are valued according to this method. This method focuses on the required rate of return of an investment (ROI) to calculate the business value. To value a business by the income approach, you need to pay attention to the following points:
- Find the Average net profit of the business over last three years using the profit and loss statement, adjusting profit for one off expenses or other irregular items each year.
- Determine the future maintainable earnings of the business according to the trends, industry features, economic outlook and a host of other factors that are relevant to predicting future maintainable earnings.
- Decide upon the relevant annual rate of return for that business bearing in mind its particular circumstances
- The rate of return is the inverse of the we call the multiplier. Return on investment of 25% means a multiplier of 4. Return on investment of 33% means a multiplier of 3 and so on.
That is,
Business value= (average net profit x the multiplier)
3. Market approach method
Before selling or buying a business, you need to know the recent sales prices of similar businesses in the market. This gives you the range of multiples. In other words, the market approach to business valuation is rooted in the economic principle of competition: that in a free market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers would not pay more for the business, and the sellers will not accept less than the price of a comparable business enterprise. It is similar in many respects to the “comparable sales” method that is commonly used in real estate business.
This is a summary of the modern approach to business valuations. For more details refer to our blog or refer to our website.
