Two Ways of Calculating the Value of a Business

Before you buy an existing business, you need to evaluate the asking price carefully. No two valuations are the same, even for companies in the same industry. Unfortunately, there is no table of factors based on company size, profits, and industry.

First, you will need to be clear on your definition of revenue versus profits. Revenue refers to gross sales before deducting any expenses, and net profits or net earnings represent what is left after deducting all the expenses of earning that revenue. When valuing a business as a going concern, one of the most important factors is calculating normalized net profits or net earnings.

There are two basic methods of valuing a business: breakup value and going concern value.

  1. Breakup value

Breakup value is calculated by taking the current market value of all assets of the business, then deducting the liabilities and reasonable liquidation fees. The resulting value is what you would end up with if you sold off the assets and paid off all the liabilities. That is the value of the business on a ‘breakup’ basis. 

  1. Going concern value

Going concern value is arrived at through a rather complicated process. This involves ‘normalizing’ earnings, eliminating the impact of assets or revenue streams that do not form part of the core asset base or main revenue stream of the business. These assets and ancillary revenue streams are valued separately. Appropriate capitalization rates reflect reasonable levels of risk given the nature of the business.

The basic question

The basic question to be answered in valuing a business is, “How much am I willing to pay someone for a business and if I am paying that amount, will I receive a stream of future income from that business annually?”

In determining this value, review the historical earnings stream, adjusting for the financial impact of unusual events such as a one-time windfall profit or an unusually large non-recurring expense. Typical adjustments may also be required to reflect such things as ‘normal’ wages of the management, reflecting what the business would have to pay in wages if it had hired a manager at market rates.

Once you have determined what the ‘normalized’ future earnings would likely be, based on historical data and trends, select an appropriate capitalization rate. Consider the level of risk associated with the business and the rates of return on other types of investments. To put this range into perspective, look up the current payout rate for Guaranteed Investment Contracts (GICs), which are risk-free and can be cashed in at any time. Compare that to venture capitalists who require annual compound rates of return in the 25% to 30% range, since they typically invest in high-risk, high-return businesses by way of unsecured equity investments. Somewhere between these two ranges is where most businesses fall.

Before making a commitment to this purchase, you should seek the advice of a professional business valuator.

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