Key concepts in valuing a business

The following are some key concepts you will need to understand when valuing a business.

Fair salary for owner

Owners who work in their business are entitled to a fair salary for their work, just as anyone else is. This is the concept of a fair salary for owner – the amount you'd pay someone else to do the hands-on work you'd do. This amount includes superannuation.

Keep in mind that fair salary is what you'd be willing to pay someone else to do your job. It doesn't include additional amounts or an inflated salary you might be willing to pay yourself.

How you choose to treat fair salary for owner in your valuation is very important.

For example, imagine you're considering buying a business for $100,000 and the annual net profit is $70,000. You discover that this figure hasn't yet had a fair salary for owner deducted which, given the hours you'd need to work on the business, is $65,000. The net profit after deducting fair salary for owner is $5,000 – the return you could expect if you put your $100,000 in a bank.

Fair return on investment (ROI)

If you have a sum of money to invest, you'll expect a return on it. If you put it in a bank, you'd get a certain return on that investment (ROI). If, instead of putting your money in a bank, you invested it in a business, the return you'd expect to make would be greater because the associated risks and level of effort required are higher.

Fair ROI refers to the return you expect to receive in the current marketplace for a riskier investment than putting funds in a bank.

The fair ROI you'd expect would be in direct proportion to the risks involved. For example, if you invested in a very speculative business venture with a high degree of risk, you'd expect a very high rate of return if it did prove successful.

Fair return on net tangible assets

A specific example of fair ROI is fair return on net tangible assets. This is the return you'd expect from the net tangible assets of a business.

For example, a business has tangible assets of $200,000, liabilities of $80,000 and intangible assets (including goodwill) totalling $20,000. The net tangible assets of this business are $200,000 minus $80,000, or $120,000. Net tangible assets include only tangible asset minus liabilities.

The fair return on net tangible assets you'd expect to get from this business, assuming you have an expected ROI of 20%, would be 20% of $120,000 or $24,000.

Super profit

Super profit is the excess a business might return you after you've taken out fair salary for owner and fair return on net tangible assets. It's the amount you'd expect to receive from the business after deducting what you'd receive if you got a job in the business and invested the money you'd spend on the net tangible assets elsewhere.

Use the following interactive calculator to help you work out your super profit. Once you have read and understood the example, you can type the numbers that are relevant to your business into the calculator to see your super profit.

Super profit

Use this formula to calculate your super profit.

Super profit = Annual profit - (Fair return on net tangible assets + Fair salary for owner)

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