How to value a business

There’s no single way to value a business and there are many factors that can impact how a valuation is reached. Getting your asking price right can help you reach a business sale faster, so it’s good to know your options.

The most common ways to value a business are:

• Current marketplace value
• Return on investment (ROI)
• Industry multiplier method
• Business assets
• Creating the business from scratch

 

Current marketplace value

If you were selling your house, you’d definitely check out other houses in your area. The same goes for selling a business.

Look around online, check out social media and look for listings in the newspaper, but wherever you choose to look, try to compare apples with apples.

For example, if you’re trying to sell a café in Blackburn, Melbourne, look at other cafes of a similar size in the same area. Then use any other information provided like revenue, expenses, products and services to help you compare.

 

Return on investment (ROI)

One of the most important questions buyers ask is, ‘how long will it take for me to make my money back?’

For this reason, working out a business’s value based on ROI is very common. It simply measures how much money a business will make versus how much it costs to buy. A high ROI tells a buyer they’ll make their money back quickly. A lower ROI tells them it will take more time.

ROIs are measured in percentages – the higher, the better.

To calculate your expected ROI:

• work out your average net annual profit over the last three years
• divide it by your asking price, then
• multiply by 100.

For example, Joe’s Sushi Hut made an average net annual profit of $20,000 over the last three years. Joe thinks a price of $100,000 is fair. So, 20,000 divided by 100,000 = 0.2. Multiply that by 100 and Joe has an ROI of 20% if he’s asking $100,000 for his business.

An ROI of 20%, tells a buyer they can expect to make their money back in five years if they buy Joe’s Sushi Hut. An ROI of 10% would tell a buyer they’ll make their initial investment back in ten years.

So, how quickly would your buyer reasonably expect to make their money back if they bought your business?

If you think ten years is reasonable, run the above calculation with different asking prices until you come close to an ROI of 10%. Five years? Adjust asking prices until you get near 20%. Two years? Look for 50%.

 

Industry multiplier method

This is a rough guide for valuing a business based on multiplying your annual revenue by an amount that is as standard for your industry. Because it assumes all businesses in the same industry are interchangeable, take it with a grain of salt.

This ‘rule of thumb’ multiplier works by multiplying profits or earnings over a set period. It can be a good starting point to value your business.

Industries usually come up with their own rules, so you’ll need to do a little digging.

For example, the manufacturing industry sometimes uses a multiplier of ‘five times revenue. If Dianne’s letterbox manufacturing business had revenue of $200,000 last year, she’d multiply that figure by five. Her business is then worth $1 million.

 

Business assets

This method uses the current value of your assets, minus your liabilities to work out a valuation.

There are two types of assets that you’ll need to value. Tangible assets are physical things you can touch, like property or equipment, while intangible assets can’t be touched and include things like intellectual property or goodwill.

Once you’ve done this, you subtract the liabilities. This might include debts, wages and other expenses.

As an example, Marco’s Patisserie might have assets valued at $320,000 and liabilities of $120,000. Using this method, the business is worth $200,000.

In practice, this method can be difficult. That’s because working out the exact value of your assets is complicated and you also have to factor in depreciation (your assets losing value over time). In addition, intangible things like goodwill (which includes customer loyalty, brand recognition and reputation) aren’t easily valued. You may get very different results depending on how you choose to value them.

For these reasons, it’s a good idea to ask a business advisor or accountant for help if you want to use this method.

 

Calculate creating your business from scratch

This method is simple and often accurate, but you do need a good understanding of ALL the costs involved in starting up a business.

For instance, say Rakesh wants to sell his gym in outer Perth. He has 178 paying members. One way to value his gym would be to estimate the cost of buying or leasing the premises and equipment, organising the systems and processes (like the web site, automated billing, etc), and then the advertising and marketing required to get the same number of members.

As you can imagine, the number Rakesh settles on is only as good as his knowledge of the costs involved.

If all those costs come to $800,000, then this is the value of his business.

 

Potential future profits – how they might affect the value of a business

It’s important to consider if a business will become significantly more profitable in the future. A buyer isn’t purchasing your past profits, but the promise of future ones.

For that reason, your final price should also take future profits into account.

Once you’ve used one of the valuation methods above, take the time to consider if your business is going to be more profitable in the future. That might be because of things like industry trends, a maturing business model, or rapidly decreasing costs.

How much this adds to the value of your business depends totally upon your circumstances.

For instance, Jane’s e-scooter business has a value of $190,000 using the ‘assets’ method. However, Jane knows the price of scooter batteries is decreasing and the market is growing fast.

She’s also just moved manufacturing to China, so her margins will be much higher in a few months. She thinks her business will be far more profitable in three years’ time as a result. For that reason, she believes her business is worth closer to $400,000.

If you’re like Jane and you believe your future profits add far more to your value, you need to robustly back it up. You’ll need to find any evidence you can to support your position and present that if asked. Financial forecasts about market size, proof of your growing profit margins, and reputable articles about emerging trends are the best ways you can do this.

 

Next steps

There are many ways to value a business, and a variety of factors that can influence your asking price. If you’re methodical and take the time to prepare your business documents, you’ll be well on your way to accurately valuing your business and getting it in front of the right buyers.

Find out the other steps involved in selling your business in our ultimate guide on how to sell a business.