There’s various ways of valuing businesses, the most common is a return on investment, you can do return on projected earnings, there’s all kinds of various ways of doing it. A return on investment is the most popular way that small to medium sized businesses are valued.
The steps are relatively easy:
- Obtain set of Abridged Financial Statements with preferably three years’ worth of information.
- Adjust these for situations relative to yourself – include interest, wages for yourself
- Add the three years together and divide by 3 to get an average profitability
Its then up to the prospective purchaser to determine what return they want as a return on their investment. (This is the tricky part). When they determine if they require 25%, 20%, or 30% and then divide by that percentage of the profit to get what the business value is. It’s kind of like a rule of thumb. This is exactly the same as a multiple of profit – you work out what multiple you are content with (which is the inverse of the return on investment) and multiply the average profit by this amount to get a starting price to negotiate.
For most businesses, the rule of thumb is somewhere between two and three times the profit gives you a valuation of the business. The higher the multiple, the less reliant on the business owner, meaning that they’re not working in the business. They’re not making decisions, the staff or run at all, it might even be run by management. There are some industries that go a lot higher than three times, the ones that come to mind, a mortgage broking and financial planning, they can run as high as five or seven times even.
I listened to a podcast the other day, and the lady was a US base podcaster. She was talking about returns of five to seven times on businesses. So in the US, they must do it a bit differently to the way we do it here. Here in Australia, anywhere between two and three times is the general rule of thumb of return. So a return of three times is 33% return a rule of thumb.
That’s valuing businesses in a nutshell, if you are interested in selling, have a chat to us well in advance of when you want to exit so we can help you plan to get the best sale price possible.