5 Essential Business Valuation Methods

If you’re searching for a business to purchase, it’s essential to understand its value so you can reach a reasonable purchase price. Keep in mind that the buy business asking price set by the seller is probably far from what the business is actually worth. That’s why it’s necessary for you to conduct a business valuation to determine its true value.

A business valuation is a regular aspect of any buy business endeavour. Remember that buyers invariably value a business differently than sellers. Sellers place a high price on their business because of the history they have with it, their emotional attachment to it and the hard work they’ve put in over the years. But when you value a business, those factors should not be calculated in the purchase price.

To value a business, there are five ways to determine its worth. They are liquidation value, asset valuation, income multiple, income capitalization and rules of thumb. Before you buy a business, you need to determine which method will provide you with the best business valuation.

1. Liquidation Value. This is based on the value of the business’s assets if they had no choice but to sell in less than 12 months.

2. Asset Valuation. This method factors in all assets of a business and calculates price appropriately. It’s likely the most unpopular business valuation method for individuals pursuing purchasing a small business. That’s because even though a business may have excellent assets, it still may not make enough profit to survive.

3. Income Multiple. The net income and other factors determine the selling price. This is the preferred method to use to value a business.

4. Income Capitalization. Historical data and various hypotheses are used to calculate future income of the business. This buy business method is typically used for large business purchases.

5. Rules of Thumb. The selling price of similar businesses is factored in to cash flow or a percentage of revenue equation. Since this calculation is too general, it’s not the best way to value a business.

Of all these business valuation methods, the Income Multiple calculation is the most beneficial to buyers because it provides an accurate amount of how much profit they can expect from the business. In buy business terms, this is known as the Owner Benefit, also referred to as Seller’s Discretionary Earnings or Adjusted Earnings.

The Owner Benefit is based on past financials. It is the total sum the buyer can expect to meet salary, pay any debts and promote the business. But for a real calculated total, it’s essential to ask the seller what formula was utilized to reach at the Owner Benefit figure.

The optimal formula to use is: the pre-tax profit + owner’s salary + additional owner’s benefits or other perks + interest + depreciation less an allocation for future capital expenditures where appropriate. Previous history has shown us that this particular formula is best in terms of actual value of business accuracy.

When you purchase a business based on the Owner Benefit figure, you’ll likely pay somewhere between one to three times the business valuation total. Typically, the one-time multiple figure is used when buying a consulting business or professional service run by the seller. The three times the Owner Benefit amount is generally what businesses should receive that have been in operation for more than three years, have a large customer base, some proprietary items, a competitive advantage, and good growth potential.

The Owner Benefit is just part of the equation when you buy a business. When you value a business, actual multiples have to be taken into consideration. These include basic buy business fundamentals, such as how long it has been in business, lease terms if the location is key to the business, its competition, the employees, systems, deal terms, the extent of its customer base, loyalty of customers, past stability of the company, and most importantly, how well the business will transition to new ownership.

The multiple aspect covers all tangibles that go to the core of a business. When you buy a business, it is essential to know and evaluate what the business valuation means to you. There are resources that can assist you with these buy business methods. But if you plan to buy a business, it’s critical that you learn how to read and analyze financial statements.

Once you value a business, it will help with your decision on whether to buy it and at what price. When you implement buy business strategies, you will be more confident in negotiating a deal with terms of value that meet your needs. Understanding business valuation formulas also ensures that you will not be overpaying for the business you desire.

Richard Parker is the President and founder of the Diomo Corporation - The Business Buyer Resource Center. His inspiring materials, seminars and consulting have assisted thousands of business buyers with achieving their life long dream of buying a business.

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