Remember, the true value of a business is always what someone is willing to pay for it. To arrive at a figure, buyers use various valuation methods. This is usually just to give a sense of reassurance that they're not paying too much. Here are the main methods:
For a simple business asset valuation, add up the assets of a business and subtract the liabilities. You might want to use a business value calculator to do this.
So, if a business has $500,000 in machinery and equipment, and owes $50,000 in outstanding invoices, the asset value of the business is $450,000.
As a buyer, you could decide to just buy the assets of a business rather than take over the business as a going concern. This way, any outstanding debts or tax payments are all payable by the previous owner. Use an asset valuation if you own or are interested in a stable, asset-rich business. The starting point for a business asset valuation is the assets listed in the accounts. This is known as the ‘net book value’ (NBV) of the business. You then refine the NBV figures for the major items, to reflect economic reality. For example:
- property or other fixed assets may have changed in value
- old stock may need to be sold at a discount
- debts to the business that clearly aren’t going to be paid.
Intangible items such as software development costs are usually excluded.
Price earnings ratio
The price earnings ratio (P/E ratio) is the value of a business divided by its profits after tax. For example, a company with a share price of $40 per share and earnings per share after tax of $8 would have a P/E ratio of 5 (40/8 = 5).
When valuing a business, you can use this equation: Value = Earnings after tax × P/E ratio. Once you’ve decided on the appropriate P/E ratio to use, you multiply the business’s most recent profits after tax by this figure. For example, using a P/E ratio of 6 for a business with post-tax profits of $100,000 gives a business valuation of $600,000.
Which P/E ratio to use?
Deciding on an appropriate P/E ratio to use is not easy and you’ll have to justify your choice to a potential buyer or seller. Some industries have ‘standard’ P/E ratios for valuing a business, so ask your accountant if there are industry averages you can use.
Entry cost valuation
Rather than buy a business, you could start a similar venture from scratch. An entry cost valuation reflects what the process would cost you. To make an entry cost valuation, calculate the cost to the business of:
- purchasing or financing its assets
- developing products or services
- recruiting and training employees
- building up a customer base.
This allows you to make a comparative assessment. So, you might calculate the following:
- a cost of $500,000 to buy the set-up equipment
- a cost of $50,000 a month for overheads
- a required 12 months’ trading to get a customer base.
A business that already has all of this is worth at least $1.1m ($500,000 for equipment and $600,000 overheads for 12 months). You can now factor in any cost savings you could make, such as use of better technology, setting up in a less expensive area or other cheaper alternatives.