Select a valuation method

The real value of a business is equivalent to what buyers are prepared to pay. Before deciding how to value the business, you should establish the prices paid for similar businesses in the recent past. Accountants and business brokers will usually have access to such information. While this benchmarking cannot be treated as a formal valuation, it does provide an initial guide to the likely market price.

There are a number of methods used to value a business. No one method is more valid than another, and valuations are usually based on a combination of methods.

The 2 most common valuation methods are:

  • calculating a business's net worth (i.e. assets minus liabilities)
  • valuing based on the business's income or profits and the expected return on investment (ROI).

Valuation based on net worth

The net worth of a business is essentially the difference between what it owns (assets) and what it owes (liabilities). Assets minus liabilities equals net worth.

When calculating a business's net worth, you need to consider both tangible assets (such as machinery and equipment) and intangible assets (such as goodwill and intellectual property).

The drawbacks of this method are that valuing a business's intangible assets can be difficult. Additionally, it doesn't take into account the premium that might be justified for strong growth businesses or discounts for businesses that are in decline.

Valuation based on annual net profit

Some people prefer to value businesses based on a business's annual net profit. Many industries have a ratio for valuing a business in this way. For example, the marketplace may value a particular type of business – as long as it's secure – at 3 times its annual net profit. However, a less secure business in the same industry might sell for only twice the annual net profit.

For example, let's consider a business in a particular industry that has a net profit of $50,000. If the standard valuation for this industry is 3 times net profit, the business value will be $150,000.

The drawback to this valuation method is that is doesn't necessarily consider other factors such as an increasing or decreasing target market. For example, consider 2 businesses, each showing a net profit of $60,000 annually. If businesses in this particular industry are selling for twice the annual net profit, both businesses will be valued at $120,000. But if one business is experiencing increasing annual net profit, this method of valuation doesn't recognise it.

At this point in your valuation of a business, you'll usually need to select a valuation method or combination of methods. It's usually a combination of methods that the marketplace uses.

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