This archive report was first published on 10 January 2020.
Introduction to Business Valuation ¶
Business valuation is the process of determining the economic value of a business. It's essential for various purposes, including mergers and acquisitions, fundraising, and tax planning. The value of a business is determined by what buyers are willing to pay for it.
Before valuing a business, it's essential to establish the prices paid for similar businesses in the recent past. Accountants and business brokers usually have access to this information, which serves as a benchmark for the likely market price.
Methods of Business Valuation ¶
There are several methods used to value a business, and no one method is more valid than another. Valuations are usually based on a combination of methods. The choice of method depends on the type of business, its size, and the industry it operates in.
Net Worth Method ¶
The net worth method involves calculating the difference between a business's assets and liabilities. Assets minus liabilities equals net worth. This method is simple but has its drawbacks, as it doesn't take into account the premium that might be justified for strong growth businesses or discounts for businesses that are in decline.
Profit-Based Method ¶
Some people prefer to value businesses based on their 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 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.
Valuing Assets ¶
A business's assets are a vital part of any valuation. Buyers and sellers need to establish exactly what assets will be sold in any transaction. A business has three types of assets: current or short-term assets, non-current or fixed assets, and intangible assets.
Current Assets ¶
Current or short-term assets include accounts receivable, inventory, and other liquid assets. They're assets you could reasonably expect will be converted into cash within 12 months. To value current assets, you'll need to review the business's stock on hand and balance sheet.
Non-Current Assets ¶
Non-current or fixed assets are long-term or permanent business assets. Non-current assets include land, buildings, plant and machinery, tools, motor vehicles, and computer equipment. Non-current assets are usually valued by deducting the accumulated depreciation from the original purchase cost.
Intangible Assets ¶
Intangible assets play a major role in valuing a business. They include things like patents, copyrights, goodwill, customer lists, and intellectual property (IP). IP is difficult to value as it doesn't depreciate in the way that a tangible asset does. You should consider seeking professional assistance to value intangible assets.
Key Concepts in Business Valuation ¶
There are several key concepts you need to understand when valuing a business. These include fair salary for owner, fair return on investment (ROI), and fair return on net tangible assets.
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.
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 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. Net tangible assets include only tangible assets minus liabilities.
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.
