It is a fact that more and more people are exploring ways to purchase an existing business due to increasing financial challenges and jobs being “under thread” of retention, etc. Or perhaps just to realise a dream of “owning a business’s and being financially self reliant. Before any hard earned capital is spent in buying a business, it very important to have some understanding about the process of valuating a business. This will help all potential business owners to determine whether the asking price for a business is fair / reasonable?
Existing business owners also often ask “what is my business worth?” There are numerous methods in valuating a business or business interest e.g.:
- Extra Earning Potential
- Return on Investment
- Payback Period
- Income Flow method
- Asset based method
It has evolved into a science on its own…but for this purpose, I decided to keep it as simple as possible.
An easy way to start is by looking at the current income flow as well as expected income for the future. This method is explained in an article in Prestige Bulletin, October 2013, p10-13 as follows:
Business XYZ – current and future net profit is R100 000 per annum. High risk business therefore a new business owner or investor will expect to earn at least 30% per annum on his investment or capital spent in buying the business.
- Future annual net profit is R100 000
- Fair rate of return is 30%
- Value=Net profit divided by rate of return
The value of this business is:
R100 000/30% = R333 333 or rounded off to R300 000
This is a simplified method based on the assumption that the business will perform on a constant basis of R100 000 per annum. However, a successful business is expected to grow year on year with an annual growth in the net profit per annum.
As per example in the Prestige Bulletin, p10-13:
Income R1 000 000
Expenses R 900 000
Profit R 100 000
Income (+15%) R1 150 000
Expenses (+15%) R1 035 000
Profit R 115 000 (increased with the same ratio, i.e. by 15%)
In valuing a business, the growth in future profits should also be considered. Any successful business should at least be growing year on year to beat inflation and yield a bigger return on investment.
To valuate this business, deduct the expected growth from the expected return:
Value = Net profit / (rate of return – growth)
In the above example, we assume an annual growth of 10% per annum:
Net Profit / (rate of return – 10%)
= R100 000 / (30% -10%)
= R100 000 / 20%
= R500 000
There are always certain variables that influence the future profits of a business and needs to be considered in valuating a business. These are:
- Future net profits of a business can change year on year. Evaluate the businesses past performance year on year and the net profits realised to determine a trend in the growth. If it fluctuates, calculate an average growth year on year
- Fair rate of return expected, dependant on the risk profile of a business. Therefore determine what the expected return is on the investment compared to investing the same amount of capital in a bank. The difference is that an investment in a business has a higher risk than investing in a bank depending on the risk profile of the business / industry, this is a subjective decision.
- Stability in the current structure of the business, i.e. management, level of expertise, business strategy, cash flow profile, etc.
The above current / future profit method is a simplified way to determine a value on a business. There are always other factors to consider in valuating a business – to be discussed in a next article.
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