There are a wide variety of different methods used to value businesses. Not all methods will be suitable for every business. The valuer will use their knowledge and experience to determine the methods (or method) most suited to your business.
Here is a summary of the valuation methods most commonly used to value small to medium sized enterprises (SMEs):
Capitalisation of Earnings: This is the most widely know and used method for valuing small to medium sized businesses. The formula is as follows:
Business Value = Earnings X Multiple
This method is deceptively simple. A high level of analysis is needed to determine the ‘earnings’ figure and the ‘multiple’ that should be used for any particular business.
Comparable Transactions Method: This method compares your business to other similar businesses that have been sold in the marketplace. Most commonly, it compares the ratio of price/profit of your business compared to businesses that have been sold. However, it could also compare other data, such as price/revenue, price/asset value etc.
This method is very well suited when the ‘market value’ of the business needs to be determined. Also, methods that consider market data on business sales are preferred under the International Valuation Standards.
Rules of Thumb: Many industries have a ‘rule of thumb’ to estimate the values of businesses operating in the industry. These should always be used with caution as they do not consider all of the details (e.g. risk profile) of the business being valued. If you do use a rule of thumb, the value should always be cross checked using another valuation method.
Discounted Cash Flow (DCF): In summary, this method forecasts the likely future revenue, expenses and other cash flows of the business. It then discounts these cash flows to their present value using a ‘discount rate’.
In its most basic form, the DCF business valuation formula is:
Due to its reliance on forecasts, the DCF is considered to be somewhat subjective. It is generally best used for internal valuation purposes, rather than external market valuations.
Cost Approach Methods: These methods essentially look at the values of the assets held by the business. They include the Replacement Cost Method, Reproduction Cost Method and the Summation Method.
Capitalisation of Excess Earnings Method (Also Called the Super Profits Method): This method is unusual in that it separately values the goodwill and tangible assets of the business. It is often used for businesses that have a high level of tangible assets.