Summary

There are three overall methodologies to value a business:
1) Income-based including Capitalised Earnings and Multiple of Discretionary Earnings methods
2) Market-based including Direct Market Data and Rules of Thumb methods
3) Asset-based such as Asset Accumulation method

Introduction

You’ve spent years building your business, you treasure the friends you’ve made with customers, suppliers and even some of those competitors. However, the time has come to retire and you’d like to know what your business is worth. In this article we’ll go through the business valuation process for the purposes of selling your business. read this How to Sell your Business

If you’re looking for the process of selling a business then read the article How to Sell a Business. It’s comprehensive explanation of the process of how to sell your business from a New Zealand perspective.

If you’re looking to value a hospitality business, or just want to see another example along with the one below, then read this article Restaurant Valuation.

SME Business Valuation

Business valuation for small and medium enterprises (SME) are different from large ones. Large enterprises are valued on the basis of an economic theory called “portfolio management” or “capital asset pricing” theory. It has the normal economic assumption of rational decision makers maximising their returns, and all you need to do is calculate the net present value of future cash flows.

Yet what is immediately apparent to the SME owner is that non-financial objectives such as relationships with people, business control, employment, lifestyle, caring for family and prestige may be just as critical as financial objectives. Decisions are not based solely on risk and return, indeed it has been said that owner-operator firms cannot be valued using these economic theories because they have fundamentally different drivers from the proverbial rational man.

With this in mind, we use a number of different valuation methods, sometimes these are consistent with economic theory, sometimes they aren’t (e.g. rules of thumb).

Before we get to the process, let’s make a few qualifiers.

Yes, but…

Firstly, you’re not a “fast growth” company where revenue generally exceeds 100% growth over the previous year, for examples see the Deloitte Fast 50. I may cover some relevant valuation methods but this article is not written for you.

Secondly, you’re not a large company (worth about NZ$30+ million). If you are, then your company may be valued using a different business valuation method. Valuation will be more closed tied to economic theories including portfolio management theory and capital asset pricing model as mentioned above.

Thirdly, a business valuation is simply a starting point for the final price of the business, rather than a “value” that is written in stone and shall not be broken. The final price will be an outcome of how motivated the buyer and seller is, and the strength of their respective negotiating skills. The final price may be higher or lower than the business valuation, though hopefully within the business valuation range if you’ve done a good job with the process. Valuation is a necessarily subjective process that includes some tools that unfortunately hint at an exact objective value. It may also easily go out of date (e.g. a price war starts), indeed a professional valuation gives an “as of” date.

Fourthly, we’re assessing “fair market value” which means a willing, prudent and knowledgeable buyer and willing seller in an open market reaching a price (see formal definition under “market value“). We do not mean “fair value” (specific to a particular buyer, in a sales process closed to other potential buyers), liquidation value, fire sale value or other types of investment value.

Fifthly, most NZ small and medium sized business sales are sold on an assets basis. “Goodwill” is simply the amount left over from the price after subtracting tangible assets and usually not valued separately.

Sixthly, we assume a going concern, not a business that is going to be liquidated, and you will be selling 100% not a minority shareholding.

Lastly, the only people who can give you a formal “business valuation” are certified business valuers. They are often used when there are disputes between shareholders or in a valuing a business for the purposes of marriage separation. They charge $1000s for a formal business valuation and can be expert witnesses in court. Business brokers or accountants on the other hand, will prepare a “business appraisal” of how much your business is worth. When I refer to business valuation I do not mean the formal “business valuation” that will stand up in court, but rather the every day English usage, used as part of preparing your business for sale and, strictly speaking, would be called “business appraisal”.

In summary, this article is written for a normal small or medium business in New Zealand, valued as low as $250,000 or as high as $25 million.


Business Valuation Principles

There are three principles of valuation: Principles of Anticipation, Substitution and Reproduction.

The Principle of Anticipation is where we value the current worth of future benefits of the business, and use the Income-based valuation methodologies including Discounted Cash Flow, Capitalised Earnings, and Multiple of Discretionary Earnings methods.

The Principle of Substitution is where we value a business based on the cost of acquiring an equal substitute, and have the Market-based valuation methodologies including Direct Market Data and Rules of Thumb methods.

The Principle of Reproduction is where we value what it would cost to establish a similar business, and have the Asset-based business valuation methodologies including the Asset Accumulation method.

We’ll cover the Income-based methods first.


Income-based Methods

Income-based valuation methodologies including Discounted Cash Flow, Capitalised Earnings, and Multiple of Discretionary Earnings methods.

Discounted Cash Flow

Fair market value (or present value) = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1

You are probably not going to use this one, but it is well known and worth reading to review the concept of present value. Discounted Cash Flow (DCF) is the traditional way to value an enterprise—with the stress on the word “enterprise”. It is theoretically perfect, a work of finance art, it makes financiers on Lambton Quay applaud with pride—but it is never used in the SME world (unless a corporate uses it to value a SME, like I used to at Fletcher Challenge). We’ll use a simpler variation of it called the Capitalised Earnings Method, but in order to describe Capitalised Earnings I need to quickly cover discounting and capitalising of future profits.

Would you like money now or in one year’s time? You know if you put the money in the bank it will be worth more in one year’s time, so you value money more now than in the future. Future money is worth less by the amount of your discount rate, often the interest rate. But there is nothing all that simple about this calculation, and the complexity requires assumptions that start to make a mockery of the additional complexity. Here’s what you would do:

  • forecast cash flow (not earnings, including capex and working capital) over the next five (or ten) years
  • add a figure called terminal value that calculates years 6+ (for the “perpetual” profits)
  • discount the cash flow and terminal value by the appropriate year discount rate (that is set to equal weighted average of equity and debt, called WACC)
  • add them together
  • and, hey presto, you have your business value.

But how accurate are your earnings forecasts, and what rate do you use?

Small and medium sized businesses struggle to make five year forecasts, and the particular discount rate (WACC) is hard to calculate outside of the stock market. If you forecast profits five times higher in year five versus year one, your business valuation skyrockets…is a buyer really going to believe this? If you really do, then perhaps you should hold the business for another five years, or at least do a partial sell down of shares rather than selling your business. Certainly a buyer would require those spectacularly higher profits to be paid as an earn out in future years not cash at settlement.

This valuation method is best for stock market analysts and, corporate financiers analysing larger companies. However, it can be used for businesses with very predictable forward revenue streams, and high growth companies. The latter are getting 100% growth in revenue year on year and can make a good case for this approach. Though even in these cases it may be better to use a simpler method, as I’ll now outline.

Capitalised Earnings Method

Fair Market Value = Earnings / Capitalisation rate

Say you bought a government bond that would pay interest forever. The bond cost you $1,000,000 and the interest rate was 3%. You would expect to receive $1,000,000 * 3% = $30,000 forever. Now let’s say you wanted to sell your bond. The price you would get would be the earnings / interest rate, or $30,000 / 3%, which equals $1,000,000. I hate algebra too, but the point is that this is a simple method for calculating future discounted cash flows by using one earnings figure and one rate.

Much simpler! No making ridiculous assumptions about the next five years of growth and WACC discount rates. It is best used for a mature business with stable earnings that are predicted to continue. But it still requires considerable analysis and care to estimate earnings and the appropriate capitalisation rate. First earnings.

Earnings

Let’s go through the different earnings figures.

Gross Revenue
-less cost of sales
Gross Profit | GP
-less operating expenses (excluding owner personal expenses)
Owner’s discretionary cash flow |  EBPITDA (or ODCF or SDCF)
-less owner’s salary
Earnings before interest, tax, depreciation and amortisation | EBITDA
-less depreciation and amortisation
Earnings before Interest and tax | EBIT
-less interest
Earnings before tax | EBT
-less tax
Net Profit After Tax | NPAT

I use Earnings Before Proprietors drawings, Interest, Tax, Depreciation and Amortization clumsily known as EBPITDA and pronounced “eb-pit-da”. This is also the earning figure for the Multiple of Discretionary Earnings we go over below. We use this because it includes all the cash flow benefits of owning the operation.

You can make an argument for using EBIT plus owner’s salary (at market rates) and owner personal expenses. You include a capital expenditure figure which may be the depreciation expense or this may be substituted for average capital expenditure over the last five years. When I did my business masters degree, I had an old and eccentric professor who had retired from the business world into academia, he didn’t really care which one we used, but if pushed preferred NPAT. I recommend EBPITDA.

Note a key difference between a small business and a large one. We include the owner’s salary (and any personal expenses they put through the company) as part of earnings, whereas, a corporate would keep this as an expense reflecting the fact that shareholders don’t get the benefit of the CEO’s salary. At some point the company moves from being a small business to a medium one, big enough to include an owner’s salary in expenses rather than profit, at which stage EBITDA may be the better earnings base.

What we want are “Future Maintainable Earnings” (FME), so the most recent year will be probably best earnings figure to use. However, if the earnings are fluctuating then an average of the last 3 or 5 years may be used, perhaps with the most recent year being given higher weighting.

Example
NPAT is $300,000, tax is $20,000, interest is $10,000, depreciation and amortization is $10,000, owner’s salary is $100,000 (and is at market rates), he pays golf club fees of $1500.

NPAT $300,000
Plus tax $20,000
Plus Interest $10,000
Plus Depreciation and Amortization $10,000
Plus Owner’s Wages/Salary in Overheads $100,000
Plus Discretionary Expenses $1500
EBPITDA $441,500

So our earning figure in this example is $441,500.

I’d suggest that vague external risk factors are not built into future earnings as this is better left to the risk part of the equation – the capitalisation rate. If you build riskiness into both you may end up double counting risk, so to speak.

Capitalisation rates

Let’s go back to that hypothetical government bond that has an interest rate of 3%. The NZ government is not going to go bust, so we’re happy handing over our money for a miserly 3%, low-risk low-return. Let’s say we want to give it to Westpac, now we know the big Australasian banks are secure but it’s not the government so we expect more, say 5%. Then we have the finance companies, let’s ask for 10%…as our analysis of risk increases so does our demand for a higher return.

If we have a bond paying $100,000 with a rate of 3% we value it at $100,000/0.03=$3,333,333. If we have a bond from that finance company at 10% then $100,000/0.10= $1,000,000, the higher the rate the more the bond is discounted.

Note the following:

  • a small change in the capitalisation rate leads to big changes in valuation.
  • if you divide 1 by the capitalisation rate you get a multiplier e.g. 1/0.16=6.25 or 1/0.33=3. In the next section we’ll use these multipliers which are a type of short hand for a capitalisation rate.
  • the actual formula is: capitalisation rate = Discount rate plus Growth rate. But there are so many parts to the discount rate that I’ll include the growth rate as just another part.

Build up the rate

You can use different methods to arrive at a capitalisation rate. Here we’ll use the build-up method. Later we’ll go through a multiplier method. In this method we keep adding increments to the rate as we assess different risks.

Risk-free rate and Equity Risk Premium

We start with the risk free rate, which in NZ is arguably the five year government bond. We then add an equity risk premium to recognise the risk of a business (rather than say bonds or property). NZ Treasury (October 2016) has provided a risk free rate of 2.48% (round up to 3%) and an equity risk premium of 7%.

Specific Company Risk Premium

Then we add a specific company risk premium based on risk factors identified with the industry and the specific company. This is where your work begins…

One simple way to illustrate different levels of company risk is the Schilts Risk Premium Guidelines, from lowest to highest risk:

  • Established businesses with a strong trade position, well financed, with depth in management, whose past earnings have been stable and whose future is highly predictable.
  • Established businesses in a more competitive industry that are well financed, have depth in management, have stable past earnings and whose future is fairly predictable.
  • Businesses in a highly competitive industry that require little capital to enter, no management depth, a high element of risk and whose past record may be good.
  • Small businesses that depend upon the special skill of one or two people. Larger established businesses that are highly cyclical in nature. In both cases, future earnings may be expected to deviate widely from projections.
  • Small “one person” businesses of a personal services nature, in which the transferability of the income stream is in question.

Schilts applies increases the risk premium at each stage until the last one is about five times higher than the first one (they are for the US so I haven’t listed the rates). The more stable the earnings, management and the industry the lower the risk premium. Conversely the more volatile earnings, competitive the industry, and reliance on one or two people, the higher the risk premium.

We start with business size, earnings, how long the business has been in operation, and the depth of management and staff. We consider access to finance, marketing capability, customer concentration, the condition of plant, product range, supplier relationships, distributor relationships, leasing arrangements, licenses/franchises and more.

We might use Porter’s Five Forces model that includes good analysis of the industry:

  • How intense is the competition and how powerful are they?
  • How powerful are suppliers when it comes to bargaining?
  • How powerful are customers when it comes to bargaining?
  • What’s the threat of new entrants, how low are barriers to entry?
  • What’s the threat of substitute products or services?

Lastly, how about technological disruption, and industry legislative changes or political risk?

The “Risk Rate Component Model” does this by quantifying a subjective process by scoring and weighting factors in these categories, where each category has equal weight:

  • Competition
  • Financial Strength
  • Management Ability and Depth
  • Profitability and Stability of Earnings

You rate each one from high risk 10 – medium risk 5 – no risk 0.

For example, Competition is made up of these eight factors:

  • Proprietary Content (including Patents & Copyrights)
  • Relative Size of Company
  • Relative Product or Service Quality
  • Product/Service Differentiation
  • Covenant not to compete Market Strength – Competition
  • Market Size and Share
  • Pricing Competition
  • Ease of Market Entry

But I’m going to cut to the chase here, because I want to use a similar table in the next section (Certified Business Brokers Appraiser’s Analysis Table). The Specific Company Risk Premium tends to be about 30%.

Growth rate

Lastly you need to estimate long term growth rate. Like estimating your earnings, start off with last year’s growth rate, then consider the average growth rate of the last five years, perhaps weighted towards last year. For a stable business this could be 0% to 5%.

Final Capitalisation Rate

Capitalisation rate = discount rate – long term growth rate or
Capitalisation rate = (risk free rate + equity risk premium + specific company risk premium) – long term growth rate.

Example
Let’s assume the risk free rate is 3%, the equity risk premium is 7%, the specific company risk premium is 25% and there is long term growth rate of 2%. The capitalisation rate is:
33% = 3 + 7 + 25 – 2

Fair Market Value using the Capitalised Earnings Method

Fair Market Value = Earnings / Capitalisation rate

From the examples above:
Earnings is $441,500, capitalisation rate is 33%, so Fair Market Value is:
$1.337 million = $441,500/0.33
(plus stock at valuation and working capital)

Though you would usually have a range rather than a single number using lower and higher estimates of Earnings and the Capitalisation rate. Perhaps it would be more like $1.3mn to $1.4mn.

Similarity with other methods

Divide 1 by 0.33 equals 3, put another way the multiplier is 3 times earnings. This multiplier makes it comparable to the Multiple of Discretionary Earnings and Direct Market Data methods, and allow you to take the three values to “triangulate” the multiplier to check for method agreement (which we will do at the end).

Stock market Multiples

Often people look to the stock market for multiples. They see companies having multiples of 10 or even 30+. The problem is that stock market companies are not directly comparable to SME businesses. The stock market:

  • is much more liquid, investors can exit their stocks quickly and easily
  • has less risk in the key person, say the founder, leaving or experiencing a health issue
  • are large companies with more diversified earnings which are accordingly less volatile and less risky
  • (on the other hand, stockholders don’t have control, whereas, a SME owner does, a positive factor

Perhaps stock market PE ratio proportional changes can be applied to SME company proportional changes, but even that is arguable.

Multiple of Discretionary Earnings Method

Also known as “Multiple of Sellers Discretionary Cash”, and other like worded descriptions.

Fair Market Value = Earnings * Multiplier

Seem similar to the Capitalised Earnings method? That’s because it is, except we times earnings by a multiplier—algebraically the same as dividing by a capitalisation rate. The route to the multiplier is different, though the earnings figure is the same.

It is best used where industry sectors (especially franchises) with strongly established valuation models

Earnings

In the Capitalised Earnings method we used Earnings Before Proprietors drawings, Interest, Tax, Depreciation and Amortization known as EBPITDA. We use the same in this method, and, unlike Capitalised Earnings, there is no discussion about whether to include depreciation or owner’s salary at market rates. All we care about is cash flow to the owner after normalising the accounts for things like the “daughter doing the books”, the trip to Fiji for “business”, the owner’s Mercedes lease rather than a Toyota lease…

Multiplier

Just like the capitalisation rate, small changes in the earnings multiplier can make large changes in the business value, so it’s important to have a good process to selecting the multiplier.

There are many variations of this but they all tend to take key risk factors, score them, and sometimes weight them, before adding them together and dividing to reach one average number.

An American valuer Jeff Jones came up with this method, and the business broker industry has developed variations of it, including one published by Certified Business Brokers for businesses selling in the $50,000 to $500,000 range.

They look at the risk factors, rate them, weight them, add up the weights and the weighted value, divide the two to come up with multiple between 0 and 3.

Certified Business Brokers Appraiser’s Analysis Table
10 Historical Profits
0.1-1.0 Negative to break even
1.1-2.0 Positive, but below industry norm
2.1-3.0 Industry norm or above

9 Income Risk
0.1-1.0 Continuity of income at risk
1.1-2.0 Steady income likely – three to five years
2.1-3.0 Profitability assured – five plus years

8 Terms of Sale
0.1-1.0 Seller requires all cash
1.1-2.0 Reasonable terms available
2.1-3.0 Exceptional terms available

7 Business Type
0.1-1.0 Service business with few assets
1.1-2.0 Equipment and/or inventory are significant component of total value
2.1-3.0 High cost of entry, equipment and/or inventory are major component of total value

6 Business Growth
0.1-1.0 Declining and further decline likely
1.1-2.0 Flat or at inflationary levels
2.1-3.0 Rapid growth with more expected

5 Location/Facilities
0.1-1.0 Less than desirable to tolerable
1.1-2.0 Acceptable to average
2.1-3.0 Above average to superior

4 Marketability
0.1-1.0 Limited market – special skills required
1.1-2.0 Normal market – needed skills available
2.1-3.0 Large market – many qualified buyers

3 Desirability
0.1-1.0 No status, rough or dirty work
1.1-2.0 Respectable and satisfactory
2.1-3.0 Challenging and attractive environment

2 Competition
0.1-1.0 Highly competitive and unstable market
1.1-2.0 Normal competitive conditions
2.1-3.0 Little competition/high start-up cost

1 Industry
0.1-1.0 Declining and further decline likely
1.1-2.0 Flat or at inflationary levels
2.1-3.0 Rapid growth with more expected

Example

Categories | Selected | Weight | Weighted
Multiple Values
Historical Profits 2.00 10 20.00
Income Risk 1.50 9 13.50
Terms of Sale 1.50 8 12.00
Business Type 2.00 7 14.00
Business Growth 0.50 6 3.00
Location/Facilities 2.00 5 10.00
Marketability 2.50 4 10.00
Desirability 2.50 3 7.50
Competition 0.50 2 1.00
Industry 0.50 1 0.50
Total 55 91.50
Selected Multiple 1.66

Note it is purposely capped at a multiple of 3, some industries may deserve a higher cap, perhaps 4 or 5.

Macleod (NZICA, 2014) uses a table without weighting, capped at 5, with the following factors: historical profits, income risk, terms of sale (all cash vs vender financing), business type (significant assets), business growth, location/facilities, marketability (number of buyers), desirability (dirty vs attractive), competition, industry growth, employees (key people), and goodwill transferability (company not owner profile).

Example
Fair Market Value = Earnings * Multiplier

Let’s say, earnings of $441,500 and a multiplier of 2.5, assuming no adjustments. Fair Market Value is:
$1,103,750 = $441,500 * 2.5
Though you would likely have a range, say $1mn to $1.2mn.
(plus stock at valuation and working capital)


Market Method

Market-based valuation methodologies include the Direct Market Data and Rules of Thumb methods.

Direct Market Data Method

Fair Market Value = Earnings * Earnings Multiplier (OR Sales * Sales Multiplier)

Also known as the Comparative method. Using this method you find the earnings multiples of similar businesses, adjust for differences, and multiply by your earnings to arrive at fair market value.

The justification for using the approach is to not pay more for one business than a similar one down the road. And why would you get professional to value a business on theoretical basis, no matter how experienced, when you can see what is happening in the market of similar business sales. In fact, the professional will be probably using this method, but you get the point.

It is a very popular method along with Multiple of Sellers Discretionary Cash, Capitalised Earnings and Asset based method.

Normally the price to earnings ratio or PE ratio is used. We’ve discussed above how to calculate earnings, once again we will use Earnings Before Proprietors drawings, Interest, Tax, Depreciation and Amortization known as EBPITDA (you can argue using other earnings bases like EBIT or NPAT).

However, given the subjective nature of agreeing on earnings (base, year etc.), sometimes a price to sales (gross revenue) ratio is used. This may be the case with small businesses which have similar gross and net margins (e.g. cafes).

The service NZ business brokers use is BizStats. It acts as a NZ database of business sales statistics and you can access this for a fee. You nominate the number of business sales, an industry and some other data. They send you back some statistics (it is a paper based system rather than a CoreLogic-type IT database reporting system).

Note you will need to check asset size as it may include surplus assets such as property. It calls earnings ‘EBPIDT and “Sellers Discretionary Cash”‘, which is the same as our EBPITDA. It will include location, sales revenue, gross profit and some other information. This information allows you to see if your business really is comparable to others.

Process

1) collect information on business of the same size, type and location
2) calculate the PE ratio multipliers and the average PE ratio
3) consider whether your particular business should be the same, higher or lower than the PE ratio
4) multiply the PE ratio by earnings to get Fair Market Value

Example
Wellington Plastics Distributor, with an EBPIDTA of $441,500

1) Collect information (from BizStats, example only using ‘Category 623 Plastics’)

Location | EBPIDT | Total Sales Price | Selling EBPIDT Multiple
Wellington $400,000 $1.200mn 3.00
Wellington $500,000 $1.635mn 3.27
Hamilton $410,000 $1.066mm 2.60

2) Multiple average 2.96 = (3.00+3.27+2.60)/3

3) Looking at the data it is felt the Wellington business are more representative of the distributor given the competition in the Auckland/Hamilton/Tauranga market. The Wellington market has also consolidated recently with prices starting to rise given the lack of competition. You decide a Multiplier of 3.0-3.3 is correct.

4) Calculate Fair Market Value
Fair Market Value = Earnings * Earnings Multiplier
= $441,500 * 3.0 = $1.32mn
= $441,500 * 3.3 = $1.46mn
Fair Market Value = about $1.3 to $1.5 million, say $1.4 million.
(plus stock at valuation and working capital)

Rules of Thumb Business Valuation

Rules of Thumb come in various forms, perhaps the best known one is cafes being worth “15 times one week’s sales”, another common rule of thumb “1 X Revenue” used for accounting or veterinary practices, hotels, and Internet Service Providers, or “5 X earnings” for manufacturing firms.

They are a contentious way to value a business. The biggest issue is understanding exactly how to calculate the earnings figure. Another is where a competitive change has happened in an industry e.g. recent price war, consolidation. They are effectively a guess that doesn’t take into account a company’s unique advantages.

But they might be self-fulfilling prophecies. They may have been used for so long they become the valuation method, especially in sales between individuals not represented by a business broker or accountant.

They are also simple to use and often avoid earnings calculations by using a revenue rule of thumb.

This an area where I may do some NZ research to substantiate what’s happening in NZ.


Asset Based

Asset-based business valuation methodologies include the Asset Accumulation method.

Asset Accumulation Method

Fair Market Value = plant + stock + intangible

Also known as Notional Realisation of Assets, Adjusted Book Value Method, and Asset Accumulation Method.

All assets are valued and added together to calculate total asset value and business valuation (though owner’s value will be net of liabilities). These are normally plant, stock and the types of intangibles that are saleable and can be valued.

Note it is usually not book value. IRD accepts depreciation rates for the purposes of calculating net profit. However, often these rates do not reflect reality, sometimes assets are actually appreciating value e.g. foreign exchange can affect plant valuation because it is based on overseas USD plant sales. Sometimes book value is used when it approximates asset value e.g. retail store chattels.

Often the plant requires specialist valuation. I was involved with selling an aviation business where negotiations were around which specialist asset valuation was correct, rather than which earnings figures.

When to use:

  • when there is a heavy asset based and comparatively low earnings e.g. an earthmoving company or an aviation tourism business
  • when there is a poor earnings record
  • when there is an uncertain future e.g. a tourism business that has a DOC permit about to expire

Example
Let’s say the manufacturing plant has been valued at $600,000, stock at valuation (SAV) was $250,000, intangible assets were not regarded as valuable.

Fair Market Value = plant + stock + intangible
$850,000 = $600,000 + $250,000 + 0

Unless this is a capital intensive business then other methods are likely to be more accurate (and much higher). It may make sense for this company to see if it has assets that are surplus to requirements and can be sold without changing earnings.

Cost to Create

This is similar to the Asset Accumulation method in that it adds together business establishment costs—how much would it cost to get a similar business to a similar level of growth. It is unlikely to make allowance for goodwill. It is often used for small start-up businesses or loss making business.

Other methods not covered

There are other methods that a business valuer and some business brokers may choose to use in particular circumstances that we won’t cover here. These are Excess Earnings, Super Profit, and Capitalised Dividends.


Final Business Valuation

You’ve chosen your valuation methods, completed the valuation, now you want to compare or triangulate the values. If they are similar that is encouraging, if not, then you may want to check your method calculations again. Note asset based valuation will often be much less than income or market methods, so you can often ignore that one.

Triangulation Example
From the examples above, we have the following business values:
Capitalised Earnings $1,337,000
Multiple of Discretionary Earnings $1,103,750
Direct Market Data $1,400,000
Asset Based $850,000

Ignoring Asset based (this is not an asset heavy business), we see we have a low figure of about $1.1 mn, mid figure of $1.3mn and high figure of $1.4mn. Based on this you review the Multiple of Discretionary Earnings and decide you may have been a little harsh which brings the figure up to $1.3 million. Note you then need to add stock at valuation and working capital to these figures.

Before we finish the valuation, we want to make a common sense check or sanity test of our results.

Sanity Test

Would you buy this company at this price, or would you sell this company to your best friend at this price? Does it make common sense?

Does the valuation give the buyer:

  • a reasonable wage
  • debt service payments
  • adequate return on investment?

Example
Let’s assume a reasonable wage is $100,000 pa, debt service payments are $50,000 pa (perhaps on $500,000 debt), and he wants at least a 20% pa ROI. Earnings are $441,500. Let’s assume a Fair Market Value of $1.4mn including stock at valuation and working capital.

ROI at 20% is $280,000.
Wage of $100,000
Debt service of $50,000
Total of $430,000 cash flow needed.
Earnings forecast of $441,500 is $11,500 more than minimum expected cash flow. This valuation makes common sense.


Summary

There are three overall methodologies to value a business 1) Income-based 2) Market-based and 3) Asset-based. SME businesses use the Income-based methods Capitalised Earnings, and Multiple of Discretionary Earnings; the Market-based methods Direct Market Data and Rules of Thumb; and the Asset-based method Asset Accumulation.

Income and Market methods assume an earnings figure that is a cash-flow based and includes all owner benefits including owner salary called EBPITDA.

The Capitalisation Earnings method calculate fair market value by dividing earnings by a capitalisation rate.

The Multiple of Discretionary Earnings method multiplies earnings by an earnings multiplier that comes from similar business sales in a central NZ market database.

The Asset Accumulation method, values assets at market rates and adds them together.

Lastly, the various methods are compared or “triangulated” and a sanity test is applied to make sure the value makes common sense.

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